Rent Abatement As Liquidated Damages Or Unenforceable Penalty?

The problem with the trial court's analysis is that it took the concept of proportionality as it applies to liquidated damages to an extreme, going beyond the protections the rule was intended to provide. Requiring that a liquidated damage provision specify an amount for each individual work item with the specificity that the trial court ruling required is contrary to the concept of liquidated damages. Liquidated damages provisions are for complicated breaches where the parties are unable to quantify the money damages. Therefore, how can the parties determine, 'a set amount of rent abatement for each item breached, without first quantifying that which they agree is unquantifiable?'

Such was the rational of the Appellate Division when it reversed the trial court ruling and held that the rent abatement provision in Bates was a valid liquidated damages clause. In coming to this conclusion, the court relied on testimonial evidence that established that it would be difficult, if not impossible for the parties to calculate the tenant's damages resulting from a breach because there would be no way of knowing whether the loss of a client was directly related to the owner's failure to bring the building up to the agreed upon standard.

In addition, the court relied on the precedent set in Seidlitz v. Auerbach, 230 N.Y. 167 (1920), and later confirmed in LeRoy v. Sayers, 217 A.D. 2d 63 (1st Dept. 1995), which articulated the governing rule on liquidated damages provisions. Both Seidlitz and LeRoy specify that a liquidated damages provision fails when the parties have made no 'attempt to proportion ' damages to actual loss.' Seidlitz at 174. In other words, liquidated damages provisions are enforceable so long as the parties make some sort of rational distinction between varying degrees of breach. By breaking down the agreed upon improvements into two categories, with each category subject to its own rent-abatement, it was clear to the Appellate Division that the parties made every reasonable effort to provide for appropriate compensation in the event that the owner breached his obligation to repair/improve the building, and in so doing clearly adhered to the rule in Seidlitz and LeRoy.

The decision in Bates has consequences that reach far beyond the parties directly involved, profoundly impacting commercial office leases in New York and beyond. Attorneys can ensure that neither landlords nor tenants obtain benefits in gross disproportion to the injury they have suffered, rendering the liquidated damages provisions in their leases unenforceable as penalties, by using Seidlitz and LeRoy as guidance. Specifically, by making rational distinctions between varying degrees of harm that could occur from different types of breaches, parties can ensure that the contractual expectations embodied in leases are achieved. Moreover, by making good faith efforts to estimate the extent of the injury a party might sustain as a result of a breach of a lease provision that the parties can feel more secure that their liquidated damages provision will be enforceable. See Federal Realty Limited Partnership v. Choices Women's Medical Center, Inc., 289 A.D. 439 (2nd Dept. 2001). The following sample clause illustrates one way of handling the problem:

If items [insert letter/numerical description] of Landlord's Work has not been completed by the date which is fifteen (15) days (the 'Grace Period') after the Landlord's Work Delivery Date for any reason other than Force Majeure or a delay solely caused by Tenant, Landlord shall abate one (1) day of Fixed Rent, Operating Payments and Tax Payments for each day of such delay from the first day following the Landlord's Work Delivery Date through the date of completion of Landlord's Work as liquidated damages (and not as a penalty) for any losses sustained by Tenant as a result of such delay, with such rent abatement (if any) commencing after the completion of the rent abatement period referred to in Section. However, if items [insert letters/numerical description] of Landlord's Work have not been completed by the date which is fifteen (15) days (the 'Grace Period') after the Landlord's Work Delivery Date, for any reason other than Force Majeure or a delay solely caused by Tenant, Landlord shall abate one-half day of Fixed Rent, Operating Payments and Tax Payments for each day of such delay from the first day following the Landlord's Work Delivery Date through the date of completion of Landlord'sWork as liquidated damages (and not as a penalty) for any losses sustained by Tenant as a result of such delay, with such rent abatement (if any) commencing after the completion of the rent abatement period referred to in Section [insert section reference]. Both Landlord and Tenant acknowledge that (a) the damages that Tenant may suffer in the event of Landlord's failure to complete timely the relevant items of Landlord's Work are impossible at this time to ascertain; (b) the listing of certain items of Landlord's Work within items [insert letter/numerical description] and certain other items of Landlord's Work within items [insert letter/numerical description] rationally distinguishes between the varying degrees of harm that Tenant may suffer as a result of Landlord's failure to complete the same timely; and (c) the foregoing liquidated damage provisions are the result of reasonable efforts by both parties to provide for appropriate compensation in the event of Landlord's failure to complete timely the relevant items of Landlord's Work.

Gary A. Goodman and Michael S. Wien are real estate partners specializing in commercial leasing, and Lisa J. Teich is a real estate associate, in the New York office of Sonnenschein Nath & Rosenthal (http://www.sonnenschein.com/).

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.

The problem with the trial court's analysis is that it took the concept of proportionality as it applies to liquidated damages to an extreme, going beyond the protections the rule was intended to provide. Requiring that a liquidated damage provision specify an amount for each individual work item with the specificity that the trial court ruling required is contrary to the concept of liquidated damages. Liquidated damages provisions are for complicated breaches where the parties are unable to quantify the money damages. Therefore, how can the parties determine, 'a set amount of rent abatement for each item breached, without first quantifying that which they agree is unquantifiable?'

Such was the rational of the Appellate Division when it reversed the trial court ruling and held that the rent abatement provision in Bates was a valid liquidated damages clause. In coming to this conclusion, the court relied on testimonial evidence that established that it would be difficult, if not impossible for the parties to calculate the tenant's damages resulting from a breach because there would be no way of knowing whether the loss of a client was directly related to the owner's failure to bring the building up to the agreed upon standard.

In addition, the court relied on the precedent set in Seidlitz v. Auerbach , 230 N.Y. 167 (1920), and later confirmed in LeRoy v. Sayers , 217 A.D. 2d 63 (1st Dept. 1995), which articulated the governing rule on liquidated damages provisions. Both Seidlitz and LeRoy specify that a liquidated damages provision fails when the parties have made no 'attempt to proportion ' damages to actual loss.' Seidlitz at 174. In other words, liquidated damages provisions are enforceable so long as the parties make some sort of rational distinction between varying degrees of breach. By breaking down the agreed upon improvements into two categories, with each category subject to its own rent-abatement, it was clear to the Appellate Division that the parties made every reasonable effort to provide for appropriate compensation in the event that the owner breached his obligation to repair/improve the building, and in so doing clearly adhered to the rule in Seidlitz and LeRoy.

The decision in Bates has consequences that reach far beyond the parties directly involved, profoundly impacting commercial office leases in New York and beyond. Attorneys can ensure that neither landlords nor tenants obtain benefits in gross disproportion to the injury they have suffered, rendering the liquidated damages provisions in their leases unenforceable as penalties, by using Seidlitz and LeRoy as guidance. Specifically, by making rational distinctions between varying degrees of harm that could occur from different types of breaches, parties can ensure that the contractual expectations embodied in leases are achieved. Moreover, by making good faith efforts to estimate the extent of the injury a party might sustain as a result of a breach of a lease provision that the parties can feel more secure that their liquidated damages provision will be enforceable. See Federal Realty Limited Partnership v. Choices Women's Medical Center, Inc., 289 A.D. 439 (2nd Dept. 2001). The following sample clause illustrates one way of handling the problem:

If items [insert letter/numerical description] of Landlord's Work has not been completed by the date which is fifteen (15) days (the 'Grace Period') after the Landlord's Work Delivery Date for any reason other than Force Majeure or a delay solely caused by Tenant, Landlord shall abate one (1) day of Fixed Rent, Operating Payments and Tax Payments for each day of such delay from the first day following the Landlord's Work Delivery Date through the date of completion of Landlord's Work as liquidated damages (and not as a penalty) for any losses sustained by Tenant as a result of such delay, with such rent abatement (if any) commencing after the completion of the rent abatement period referred to in Section. However, if items [insert letters/numerical description] of Landlord's Work have not been completed by the date which is fifteen (15) days (the 'Grace Period') after the Landlord's Work Delivery Date, for any reason other than Force Majeure or a delay solely caused by Tenant, Landlord shall abate one-half day of Fixed Rent, Operating Payments and Tax Payments for each day of such delay from the first day following the Landlord's Work Delivery Date through the date of completion of Landlord'sWork as liquidated damages (and not as a penalty) for any losses sustained by Tenant as a result of such delay, with such rent abatement (if any) commencing after the completion of the rent abatement period referred to in Section [insert section reference]. Both Landlord and Tenant acknowledge that (a) the damages that Tenant may suffer in the event of Landlord's failure to complete timely the relevant items of Landlord's Work are impossible at this time to ascertain; (b) the listing of certain items of Landlord's Work within items [insert letter/numerical description] and certain other items of Landlord's Work within items [insert letter/numerical description] rationally distinguishes between the varying degrees of harm that Tenant may suffer as a result of Landlord's failure to complete the same timely; and (c) the foregoing liquidated damage provisions are the result of reasonable efforts by both parties to provide for appropriate compensation in the event of Landlord's failure to complete timely the relevant items of Landlord's Work.

Gary A. Goodman and Michael S. Wien are real estate partners specializing in commercial leasing, and Lisa J. Teich is a real estate associate, in the New York office of Sonnenschein Nath & Rosenthal (http://www.sonnenschein.com/).