Rent Abatement Clauses: Tenants Should Speak Softly, But Draft a 'Club'

In commercial lease transactions, a tenant's desire and need to occupy a space and begin transacting business often takes precedence over a landlord's ability to complete all of the bargained-for physical alterations that it has promised. The issue of determining the diminished value of the premises prior to the completion of the landlord's work is customarily resolved through the negotiation of rent abatement provisions that quantify damages where delays in the landlord's construction would lead to a breach of contract.

'Liquidated damages constitute the compensation which the parties have agreed must be paid in satisfaction of the loss or injury which will flow from a breach of contract.' (Wirth & Hamid Fair Booking, Inc. v. Wirth, 265 N.Y. 214, 223 (1934)). In determining whether liquidated damages constitute a penalty, courts have historically focused on three areas of inquiry: 1) the intention of the parties (United States v. Bethlehem Steel Co., 205 U.S. 105, 119 (1907)); 2) the ability of the parties to ascertain in advance damages flowing from a future breach (Ward v. Hudson River Bldg. Co., 125 N.Y. 230, 235 (1891)); and 3) the reasonableness of the amount stipulated (Wise v. United States, 249 U.S. 361, 365-367 (1919)). Although the intention of the parties was once considered a fundamental area of inquiry, this has been abandoned in modern case law. More recently, liquidated damages clauses have been upheld if the amount of damages can be considered a reasonable measure of the probable loss that a party would incur, and if it would be very difficult, or impossible, to determine the actual loss in the event of a breach. (Truck Rent-A-Center v Puritan Farms 2nd, 41 N.Y.2d 420 (1977)). A rent abatement clause providing for an amount that is 'plainly or grossly disproportionate to the probable loss' will be treated as a penalty and will not be enforced because 'public policy is firmly set against the imposition of penalties or forfeitures for which there is no statutory authority.' (Id. at 424). Additionally, courts review the provision as of the date of the contract, not as of the time of the breach. (Walter E. Heller & Co. v. American Flyers Airline Corp., 459 F. 2d 896, 898 (2d. Cir. 1972)).

In a free market society, it seems odd that parties may freely bargain over the terms of performance included in a contract, but are limited in their ability to bargain over remedies for breach of those same terms. In order to preserve a client's contractual expectations, due care must be taken in crafting a rent abatement clause. In Wise v. United States (249 U.S. at 365 (1919)), Justice John H. Clarke opined: 'There is no sound reason why persons competent and free to contract may not agree upon this subject as fully as upon any other, or why their agreement, when fairly and understandingly entered into with a view to just compensation for the anticipated loss, should not be enforced.' Further, '[t]he parties to the contract, with full understanding of the results of delay and before differences or interested views had arisen between them, were much more competent to justly determine what the amount of damage would be, an amount necessarily largely conjectural and resting in estimate, than a court or jury would be, directed to a conclusion, as either must be, after the event, by views and testimony derived from witnesses who would be unusual to a degree if their conclusions were not, in a measure, colored and partisan.' (Id. at 367). However, in the 88 years since Wise was published, courts have taken an active roll in deciding whether bargained-for liquidated damages are actually penalties. In the context of rent abatement clauses, counsel must ensure that the parties make rational distinctions between varying degrees of potential harm that could occur from various contract breaches, so that upon adjudication, a court will determine that the bargained-for remedy was not conspicuously disproportionate to the foreseeable loss, and therefore is not a penalty.

The Bates Decision

Rent abatement clauses have the potential to result in enormous financial consequences, as evidenced by Bates Advertising USA, Inc. v. 498 Seventh, LLC, 818 N.Y.S. 2d 161 (2006). Bates, a large advertising and marketing firm, entered into a 16-year lease to be the anchor tenant under a lease with the owner of a building located at 498 Seventh Avenue in Manhattan, which provided for a base rent exceeding $100 million over the entire term. As is standard practice, there was an exhibit to the lease for 'Landlord's Work,' consisting of 11 alterations; many of the alterations were completed prior to the date that the tenant commenced occupancy, while other improvements were to be made after occupancy. Sophisticated parties often bargain for rent abatement clauses in lease agreements where it would be very difficult, practically, to prove the value of damages arising from a breach. The parties in Bates agreed on an abatement equal to one-half-day rent for each day that any of nine alterations were not substantially completed and an abatement of a full-day rent for each day that the remaining two alterations were not substantially completed.

In a decision that threatened to have a profound impact on commercial office leases in New York City, the New York State Supreme Court (trial court) partially dismissed Bates' case, ruling that the rent abatement clause was not a liquidated damages provision, but was in fact an unenforceable penalty (Bates was permitted to pursue other contract-related damages) (Bates, order of the Supreme Court, New York County (Herman Cahn, J.) entered July 18, 2001). The Appellate Division reversed on the law, reinstated the dismissed causes of action, and remanded for further proceedings. The court reasoned that the issue the parties intended to address when drafting the rent abatement clause was not unique and that contracted-for alterations were 'a vital part of the deal.' However, the court found that it would be difficult, if not impossible, for the parties to calculate the tenant's damages resulting from the owner's failure to bring the building up to the agreed-upon standard. (Bates Advertising USA, Inc. v. 498 Seventh, LLC, 291 A.D. 2d 179 (1st Dept. 2002)). 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, specifically that a liquidated damages provision fails when the parties have made no 'attempt to proportion ' damages to actual loss.' After a bench trial, the supreme court concluded that the owner breached the lease by failing to complete the required alterations by the point in time that was 412 days after Bates had moved into the building. Bates' rent payments had totaled $4,339,528.61 for the period following the commencement date, and Bates was awarded rent credits in this amount. (Bates, orders of the Supreme Court, New York County (Herman Cahn, J.) entered March 2, 2004 and April 22, 2004).

The Appellate Division affirmed (Bates Advertising USA, Inc. v. 498 Seventh, LLC, 19 A.D. 3d 290 (1st Dept. 2005)), and the Court of Appeals granted permission to appeal. The Court of Appeals narrowed the issue to a question of law: Whether the rent abatement was a proper remedy for this breach? (Bates, 818 N.Y.S.2d at 163). The court followed the precedent in JMD Holding Corp. v. Congress Financial Corporation, 4 N.Y. 3d 373 (2005), finding that the party challenging the liquidated damages either: 1) must establish that the damages were readily ascertainable at the time of execution of the agreement, or 2) that the rent abatement was disproportionate to the foreseeable losses. (Id. at 380). The owner's counsel argued that the clause was intended to 'incentivize' the landlord, and provided 'a club over his head to make sure the work gets done.' The court held that the prospect of a breach of contract is always an incentive to comply with contractual obligations and that liquidated damages are not transformed into a penalty merely because they operate to encourage parties to comply with their contractual obligations. (Bates, 818 N.Y.S. 2d at 164).

The parties in Bates separated the agreed-upon improvements into two categories, with each category subject to a separate rent abatement. This level of detail and attention by the parties at the time the lease was drafted provided a clear basis for the court to decide that the parties had given reasonable thought to the damages due the tenant in the event that the owner breached its obligations, and in so doing adhered to the rule in Seidlitz and LeRoy. The owner fell short of its burden of proof according to JMD, as it could not prove that the bargained-for rent abatement was disproportionate to the foreseeable losses at the time of contracting.

After Bates

After Bates, practitioners subject to New York law and in jurisdictions with similar common law, are on notice to spend time and due care when drafting and negotiating a rent abatement clause, if they want to preserve their client's contractual expectations. The rent abatement clause must be drafted in sufficient detail to provide a future court with a basis to decide that at the time of contract execution, the bargained-for damages were not conspicuously disproportionate to the foreseeable losses. In situations where portions of the landlord's work will take place after the commencement date, lawyers and business people must understand that the rent abatement clause should be given as much consideration and thought as any major business term included in the lease. The Bates story is one that will resonate with the business people within a client's organization and provide a platform to launch into discussions of the potential financial impact of the terms of any proposed rent abatement clause.

Gary A. Goodman is a real estate partner specializing in commercial leasing in the New York office of Sonnenschein Nath & Rosenthal LLP. He may be contacted at 212-768-6916 or [email protected]. Michael J. Boccio is an associate at the New York office of Kaye Scholer LLP. He may be contacted at 212-836-7772 or [email protected].

In commercial lease transactions, a tenant's desire and need to occupy a space and begin transacting business often takes precedence over a landlord's ability to complete all of the bargained-for physical alterations that it has promised. The issue of determining the diminished value of the premises prior to the completion of the landlord's work is customarily resolved through the negotiation of rent abatement provisions that quantify damages where delays in the landlord's construction would lead to a breach of contract.

'Liquidated damages constitute the compensation which the parties have agreed must be paid in satisfaction of the loss or injury which will flow from a breach of contract.' ( Wirth & Hamid Fair Booking, Inc. v. Wirth , 265 N.Y. 214, 223 (1934)). In determining whether liquidated damages constitute a penalty, courts have historically focused on three areas of inquiry: 1) the intention of the parties ( United States v. Bethlehem Steel Co. , 205 U.S. 105, 119 (1907)); 2) the ability of the parties to ascertain in advance damages flowing from a future breach ( Ward v. Hudson River Bldg. Co. , 125 N.Y. 230, 235 (1891)); and 3) the reasonableness of the amount stipulated ( Wise v. United States , 249 U.S. 361, 365-367 (1919)). Although the intention of the parties was once considered a fundamental area of inquiry, this has been abandoned in modern case law. More recently, liquidated damages clauses have been upheld if the amount of damages can be considered a reasonable measure of the probable loss that a party would incur, and if it would be very difficult, or impossible, to determine the actual loss in the event of a breach. (Truck Rent-A-Center v Puritan Farms 2nd, 41 N.Y.2d 420 (1977)). A rent abatement clause providing for an amount that is 'plainly or grossly disproportionate to the probable loss' will be treated as a penalty and will not be enforced because 'public policy is firmly set against the imposition of penalties or forfeitures for which there is no statutory authority.' (Id. at 424). Additionally, courts review the provision as of the date of the contract, not as of the time of the breach. ( Walter E. Heller & Co. v. American Flyers Airline Corp., 459 F. 2d 896, 898 (2d. Cir. 1972)).

In a free market society, it seems odd that parties may freely bargain over the terms of performance included in a contract, but are limited in their ability to bargain over remedies for breach of those same terms. In order to preserve a client's contractual expectations, due care must be taken in crafting a rent abatement clause. In Wise v. United States (249 U.S. at 365 (1919)), Justice John H. Clarke opined: 'There is no sound reason why persons competent and free to contract may not agree upon this subject as fully as upon any other, or why their agreement, when fairly and understandingly entered into with a view to just compensation for the anticipated loss, should not be enforced.' Further, '[t]he parties to the contract, with full understanding of the results of delay and before differences or interested views had arisen between them, were much more competent to justly determine what the amount of damage would be, an amount necessarily largely conjectural and resting in estimate, than a court or jury would be, directed to a conclusion, as either must be, after the event, by views and testimony derived from witnesses who would be unusual to a degree if their conclusions were not, in a measure, colored and partisan.' (Id. at 367). However, in the 88 years since Wise was published, courts have taken an active roll in deciding whether bargained-for liquidated damages are actually penalties. In the context of rent abatement clauses, counsel must ensure that the parties make rational distinctions between varying degrees of potential harm that could occur from various contract breaches, so that upon adjudication, a court will determine that the bargained-for remedy was not conspicuously disproportionate to the foreseeable loss, and therefore is not a penalty.

The Bates Decision

Rent abatement clauses have the potential to result in enormous financial consequences, as evidenced by Bates Advertising USA, Inc. v. 498 Seventh, LLC, 818 N.Y.S. 2d 161 (2006). Bates, a large advertising and marketing firm, entered into a 16-year lease to be the anchor tenant under a lease with the owner of a building located at 498 Seventh Avenue in Manhattan, which provided for a base rent exceeding $100 million over the entire term. As is standard practice, there was an exhibit to the lease for 'Landlord's Work,' consisting of 11 alterations; many of the alterations were completed prior to the date that the tenant commenced occupancy, while other improvements were to be made after occupancy. Sophisticated parties often bargain for rent abatement clauses in lease agreements where it would be very difficult, practically, to prove the value of damages arising from a breach. The parties in Bates agreed on an abatement equal to one-half-day rent for each day that any of nine alterations were not substantially completed and an abatement of a full-day rent for each day that the remaining two alterations were not substantially completed.

In a decision that threatened to have a profound impact on commercial office leases in New York City, the New York State Supreme Court (trial court) partially dismissed Bates' case, ruling that the rent abatement clause was not a liquidated damages provision, but was in fact an unenforceable penalty (Bates was permitted to pursue other contract-related damages) (Bates, order of the Supreme Court, New York County (Herman Cahn, J.) entered July 18, 2001). The Appellate Division reversed on the law, reinstated the dismissed causes of action, and remanded for further proceedings. The court reasoned that the issue the parties intended to address when drafting the rent abatement clause was not unique and that contracted-for alterations were 'a vital part of the deal.' However, the court found that it would be difficult, if not impossible, for the parties to calculate the tenant's damages resulting from the owner's failure to bring the building up to the agreed-upon standard. (Bates Advertising USA, Inc. v. 498 Seventh, LLC, 291 A.D. 2d 179 (1st Dept. 2002)). 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, specifically that a liquidated damages provision fails when the parties have made no 'attempt to proportion ' damages to actual loss.' After a bench trial, the supreme court concluded that the owner breached the lease by failing to complete the required alterations by the point in time that was 412 days after Bates had moved into the building. Bates' rent payments had totaled $4,339,528.61 for the period following the commencement date, and Bates was awarded rent credits in this amount. (Bates, orders of the Supreme Court, New York County (Herman Cahn, J.) entered March 2, 2004 and April 22, 2004).

The Appellate Division affirmed (Bates Advertising USA, Inc. v. 498 Seventh, LLC, 19 A.D. 3d 290 (1st Dept. 2005)), and the Court of Appeals granted permission to appeal. The Court of Appeals narrowed the issue to a question of law: Whether the rent abatement was a proper remedy for this breach? (Bates, 818 N.Y.S.2d at 163). The court followed the precedent in JMD Holding Corp. v. Congress Financial Corporation , 4 N.Y. 3d 373 (2005), finding that the party challenging the liquidated damages either: 1) must establish that the damages were readily ascertainable at the time of execution of the agreement, or 2) that the rent abatement was disproportionate to the foreseeable losses. ( Id . at 380). The owner's counsel argued that the clause was intended to 'incentivize' the landlord, and provided 'a club over his head to make sure the work gets done.' The court held that the prospect of a breach of contract is always an incentive to comply with contractual obligations and that liquidated damages are not transformed into a penalty merely because they operate to encourage parties to comply with their contractual obligations. (Bates, 818 N.Y.S. 2d at 164).

The parties in Bates separated the agreed-upon improvements into two categories, with each category subject to a separate rent abatement. This level of detail and attention by the parties at the time the lease was drafted provided a clear basis for the court to decide that the parties had given reasonable thought to the damages due the tenant in the event that the owner breached its obligations, and in so doing adhered to the rule in Seidlitz and LeRoy. The owner fell short of its burden of proof according to JMD, as it could not prove that the bargained-for rent abatement was disproportionate to the foreseeable losses at the time of contracting.

After Bates

After Bates, practitioners subject to New York law and in jurisdictions with similar common law, are on notice to spend time and due care when drafting and negotiating a rent abatement clause, if they want to preserve their client's contractual expectations. The rent abatement clause must be drafted in sufficient detail to provide a future court with a basis to decide that at the time of contract execution, the bargained-for damages were not conspicuously disproportionate to the foreseeable losses. In situations where portions of the landlord's work will take place after the commencement date, lawyers and business people must understand that the rent abatement clause should be given as much consideration and thought as any major business term included in the lease. The Bates story is one that will resonate with the business people within a client's organization and provide a platform to launch into discussions of the potential financial impact of the terms of any proposed rent abatement clause.

Gary A. Goodman is a real estate partner specializing in commercial leasing in the New York office of Sonnenschein Nath & Rosenthal LLP. He may be contacted at 212-768-6916 or [email protected]. Michael J. Boccio is an associate at the New York office of Kaye Scholer LLP. He may be contacted at 212-836-7772 or [email protected].