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Rent Abatement As Liquidated Damages Or Unenforceable Penalty?
Sophisticated parties engaging in complex real estate transactions customarily provide for rent abatement provisions in commercial office leases in order to liquidate damages where delays in landlord's construction would lead to a breach of the contract. That is what occurred in Bates Advertising USA, Inc. v. 498 Seventh, LLC, 291 A.D. 2d 179 (1st Dept. 2002). In a decision that threatened to have a profound impact on commercial office leases in New York City, the New York State Supreme Court, New York County, a trial level court, held a typical rent abatement clause unenforceable by ruling that it was not a liquidated damages provision, but instead, an unenforceable penalty. The tenant appealed, and in a decision that saved the contractual expectations embodied in many similar commercial leases, the Appellate Division's First Department reversed, finding that nothing in the rent abatement provision created an unenforceable penalty or forfeiture, or violated the purpose of the liquidated damages rule.
Liquidated damages constitute the compensation that the parties have previously agreed should be paid in order to satisfy any loss or injury flowing from a breach of their contract. Provisions for liquidated damages have value in those situations where it would be difficult, if not impossible, to calculate the amount of actual damage. Thus, in effect, a liquidated damages provision is an estimate, made by the parties at the time of contracting, of the injury that would be sustained as a result of a breach of the agreement. Liquidated damages provisions are struck down as unenforceable penalties when they are against public policy or 'the amount fixed is plainly or grossly disproportionate to the probable loss.' Truck Rent-A-Center v. Puritan Farms 2nd, Inc., 41 N.Y. 2d 420, 425 (1977).
In Bates, an advertising company entered into a lease with the owner of a building who, by the terms of the lease, agreed to make substantial improvements and renovations to the building. As with many commercial leases that require improvements, some of the improvements were to be made before the tenant commenced occupancy, while other improvements were to be made after occupancy. It would be extremely difficult for the tenant to prove the value of its damages arising from a breach of the contract due to the owner's failure to make certain improvements. The lease, therefore included a rent abatement provision to liquidate damages. The parties made a significant effort to ensure that in the event of default the compensation provided for in the liquidated damages provision was proportionate to the contemplated loss. They did this by breaking down the contemplated improvements into two categories: a) nine work items for which the plaintiff would be entitled to a half-day rent abatement for each day any of them remained uncompleted; and b) two work items that were so material that the plaintiff would be entitled to a full-day rent abatement for each day either of them remained incomplete. Despite this effort, the trial court held the compensation disproportionate, and thus struck down the liquidated damages provision as a penalty, due to the fact that the half-day abatement applied whether one item or all nine items remained unsatisfied.
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