An Exculpatory Clause Is Not a 'Get Out of Jail Free' Card

Until recently, it appeared that exculpatory clauses could exonerate a party from liability under all circumstances. According to case precedent, in a landord/tenant context, it seemed as though a landlord need only cite economic self-interest as the basis for its non-performance under the lease agreement and enforce the exculpatory clause against its tenant, thereby limiting the tenant's remedies to specific performance, injunctive relief, and/or arbitration.

The purpose of an exculpatory clause is to limit the landlord's liability for monetary damages in the event of the landlord's non-performance under the lease agreement. Essentially, the exculpatory clause prevents the tenant from claiming monetary damages for lost income, loss of profits, and/or loss of business. While it is common business practice in commercial leasing to use an exculpatory clause, 'it is well settled that a commercial lease represents a 'valuable property interest' for which equitable protection is available.' (Banc of America Securities LLC v. Solow Building Company II, L.L.C. No. 9931 slip op. 09545 (N.Y.App. Div. Dec. 4, 2007) ('Solow')). Accordingly, the tenant's property rights can be severely handicapped if the landlord's conduct remains unrestricted.

For example, if a landlord fails to repair the leased premises in a timely fashion, thereby causing the commercial tenant to lose business income, an exculpatory clause would only allow the tenant to seek an order from the court demanding that the landlord repair the premises or, alternatively, seek redress through arbitration. The tenant would not be entitled to recover its loss of business income from the landlord. This dynamic effectively reduces the landlord's motivations to cure its breach because a cost-benefit analysis reveals that the landlord is better served (i.e., an economic self-interest) by allowing the breach to continue, which would trigger the protection of the exculpatory clause.

See Metropolitan Life Insurance Company v. Noble Lowndes Inter- national, Inc., 192 A.D.2d 83, 87-88, 600 N.Y.S.2d 212 (1993), aff'd 84 N.Y.2d 430, 618 N.Y.S.2d 882, 643 N.E.2d 504 (1994). A New York appellate court held that the exculpatory clause in a lease agreement was enforceable where 'defendant's repudiation of the agreement was motivated exclusively by its own economic self-interest in divesting itself of a highly unprofitable business undertaking in order to promote the sale of the computer software division to a competitor company.' See also Kalisch-Jarcho Inc., v. City of New York, 58 N.Y.2d 377, 385, 461 N.Y.S.2d 746, 448 N.E.2d 413 (1983)). As such, it appeared that any conduct, if motivated by economic self-interest, was protected by the exculpatory clause.

However, this is not always the case. Even though an exculpatory clause is enforceable, the courts disfavor it because it can severely impede a party's property interests. (Banc of America Securities LLC v. Solow Building Company II, L.L.C., No. 9931 slip op. 09545 (N.Y.App. Div. Dec. 4, 2007) (citing Lago v. Krollage, 78 N.Y.2d 95, 99, 571 N.Y.S.2d 689, 575 N.E.2d 107 (1991)). Also, an exculpatory clause is not to be used as a 'get out of jail free' card. Certain conduct is exempted from the protection of an exculpatory clause, e.g., an exculpatory clause is unenforceable 'when in contravention of acceptable notions of morality, the misconduct for which it would grant immunity smacks of intentional wrongdoing.' (Kalisch-Jarcho Inc., 58 N.Y.2d at 385). See Dalton v. Educational Testing Serv., 87 N.Y.2d 384, 389, 639 N.Y.S.2d 977, 663 N.E.2d 289 (1995). Where a party acts in bad faith in the performance of its obligations under the contract or engages in conduct with intent to cause harm to the other contracting party, this implied duty of good faith and fair dealing is breached. It is this type of behavior that runs afoul of public policy and renders the negotiated exculpatory clause invalid.

The Solow Decision

In Solow, the New York Court of Appeals invalidated the exculpatory clause in a lease agreement although the landlord's breach of the lease agreement was motivated by the landlord's alleged economic self-interest. The court distinguished intentional conduct from conduct that is willful and identified the type of behavior that is exempt from the protections of an exculpatory clause. (See Prosser, Torts '34, at 184, 185 [4th ed.] ('willful is a term of tort, not contract.'). In addition, the court reiterated the public policy governing enforceability of an exculpatory clause and expounded upon the interplay between economic self-interest and willful misconduct, the latter of which, even if grounded in economic self-interest, would invalidate the clause.

The Solow court invalidated the exculpatory clause because the landlord's conduct was malicious, exercised in bad faith, and intended to harm the tenant. The landlord, without reference to any lease provision and substantiation, 'demanded' an additional $6 million as a 'review fee' from the tenant, made the approval of any future alteration plans contingent on payment of this fee, declared the non-payment as a default of the lease agreement, and threatened to evict the tenant. The tenant had already invested $215 million in improvements to the premises, and the landlord's failure to approve any future alterations severely impeded the tenant's use, not to mention, an eviction would result in a loss of a valuable property.

Moreover, the landlord's misconduct extended well beyond a simple breach of the parties' lease agreement and was an attempt to impose a new contractual burden upon the tenant. The court held that 'relegating [the tenant] to the remedy of
specific performance under the exculpatory provision would permit [the landlord] to willfully breach the lease with impunity in order to exact unreasonable concessions from its tenant in clear violation of the implied covenant of good faith and fair dealing.' (Banc of America Securities LLC v. Solow Building Company II, L.L.C., No. 9931 slip op. 09545 (N.Y.App. Div. Dec. 4, 2007)).

Conclusion

The court's ruling in Solow does not disturb earlier court precedent, which upholds exculpatory clauses where the landlord's non-performance is motivated exclusively by economic self-interest. According to the Solow court, the clause is invalidated only if the economic self-interest is coupled with any conduct that is malicious, dishonest, or intended to harm the tenant. In light of the foregoing cases, the message to landlords is that an exculpatory clause is a valuable tool and that they should continue to use it to minimize their risk and exposure to damages and unnecessary expense. However, at the same time, landlords should remember that an exculpatory clause does not insulate them from liability for all conduct, especially conduct that is egregious, and that the basic principals of good faith and fair dealing cannot be circumvented and negotiated out of an agreement.

Gary A. Goodman is a partner, and Tina Patel is an associate in the real estate practice group of the New York offices of Sonnenschein Nath & Rosenthal LLP.

Until recently, it appeared that exculpatory clauses could exonerate a party from liability under all circumstances. According to case precedent, in a landord/tenant context, it seemed as though a landlord need only cite economic self-interest as the basis for its non-performance under the lease agreement and enforce the exculpatory clause against its tenant, thereby limiting the tenant's remedies to specific performance, injunctive relief, and/or arbitration.

The purpose of an exculpatory clause is to limit the landlord's liability for monetary damages in the event of the landlord's non-performance under the lease agreement. Essentially, the exculpatory clause prevents the tenant from claiming monetary damages for lost income, loss of profits, and/or loss of business. While it is common business practice in commercial leasing to use an exculpatory clause, 'it is well settled that a commercial lease represents a 'valuable property interest' for which equitable protection is available.' ( Banc of America Securities LLC v. Solow Building Company II, L.L.C. No. 9931 slip op. 09545 (N.Y.App. Div. Dec. 4, 2007) (' Solow ')). Accordingly, the tenant's property rights can be severely handicapped if the landlord's conduct remains unrestricted.

For example, if a landlord fails to repair the leased premises in a timely fashion, thereby causing the commercial tenant to lose business income, an exculpatory clause would only allow the tenant to seek an order from the court demanding that the landlord repair the premises or, alternatively, seek redress through arbitration. The tenant would not be entitled to recover its loss of business income from the landlord. This dynamic effectively reduces the landlord's motivations to cure its breach because a cost-benefit analysis reveals that the landlord is better served (i.e., an economic self-interest) by allowing the breach to continue, which would trigger the protection of the exculpatory clause.

See Metropolitan Life Insurance Company v. Noble Lowndes Inter- national, Inc. , 192 A.D.2d 83, 87-88, 600 N.Y.S.2d 212 (1993), aff'd 84 N.Y.2d 430, 618 N.Y.S.2d 882, 643 N.E.2d 504 (1994). A New York appellate court held that the exculpatory clause in a lease agreement was enforceable where 'defendant's repudiation of the agreement was motivated exclusively by its own economic self-interest in divesting itself of a highly unprofitable business undertaking in order to promote the sale of the computer software division to a competitor company.' See also Kalisch-Jarcho Inc., v. City of New York , 58 N.Y.2d 377, 385, 461 N.Y.S.2d 746, 448 N.E.2d 413 (1983)). As such, it appeared that any conduct, if motivated by economic self-interest, was protected by the exculpatory clause.

However, this is not always the case. Even though an exculpatory clause is enforceable, the courts disfavor it because it can severely impede a party's property interests. ( Banc of America Securities LLC v. Solow Building Company II, L.L.C. , No. 9931 slip op. 09545 (N.Y.App. Div. Dec. 4, 2007) (citing Lago v. Krollage , 78 N.Y.2d 95, 99, 571 N.Y.S.2d 689, 575 N.E.2d 107 (1991)). Also, an exculpatory clause is not to be used as a 'get out of jail free' card. Certain conduct is exempted from the protection of an exculpatory clause, e.g., an exculpatory clause is unenforceable 'when in contravention of acceptable notions of morality, the misconduct for which it would grant immunity smacks of intentional wrongdoing.' (Kalisch-Jarcho Inc., 58 N.Y.2d at 385). See Dalton v. Educational Testing Serv. , 87 N.Y.2d 384, 389, 639 N.Y.S.2d 977, 663 N.E.2d 289 (1995). Where a party acts in bad faith in the performance of its obligations under the contract or engages in conduct with intent to cause harm to the other contracting party, this implied duty of good faith and fair dealing is breached. It is this type of behavior that runs afoul of public policy and renders the negotiated exculpatory clause invalid.

The Solow Decision

In Solow, the New York Court of Appeals invalidated the exculpatory clause in a lease agreement although the landlord's breach of the lease agreement was motivated by the landlord's alleged economic self-interest. The court distinguished intentional conduct from conduct that is willful and identified the type of behavior that is exempt from the protections of an exculpatory clause. (See Prosser, Torts '34, at 184, 185 [4th ed.] ('willful is a term of tort, not contract.'). In addition, the court reiterated the public policy governing enforceability of an exculpatory clause and expounded upon the interplay between economic self-interest and willful misconduct, the latter of which, even if grounded in economic self-interest, would invalidate the clause.

The Solow court invalidated the exculpatory clause because the landlord's conduct was malicious, exercised in bad faith, and intended to harm the tenant. The landlord, without reference to any lease provision and substantiation, 'demanded' an additional $6 million as a 'review fee' from the tenant, made the approval of any future alteration plans contingent on payment of this fee, declared the non-payment as a default of the lease agreement, and threatened to evict the tenant. The tenant had already invested $215 million in improvements to the premises, and the landlord's failure to approve any future alterations severely impeded the tenant's use, not to mention, an eviction would result in a loss of a valuable property.

Moreover, the landlord's misconduct extended well beyond a simple breach of the parties' lease agreement and was an attempt to impose a new contractual burden upon the tenant. The court held that 'relegating [the tenant] to the remedy of
specific performance under the exculpatory provision would permit [the landlord] to willfully breach the lease with impunity in order to exact unreasonable concessions from its tenant in clear violation of the implied covenant of good faith and fair dealing.' ( Banc of America Securities LLC v. Solow Building Company II, L.L.C. , No. 9931 slip op. 09545 (N.Y.App. Div. Dec. 4, 2007)).

Conclusion

The court's ruling in Solow does not disturb earlier court precedent, which upholds exculpatory clauses where the landlord's non-performance is motivated exclusively by economic self-interest. According to the Solow court, the clause is invalidated only if the economic self-interest is coupled with any conduct that is malicious, dishonest, or intended to harm the tenant. In light of the foregoing cases, the message to landlords is that an exculpatory clause is a valuable tool and that they should continue to use it to minimize their risk and exposure to damages and unnecessary expense. However, at the same time, landlords should remember that an exculpatory clause does not insulate them from liability for all conduct, especially conduct that is egregious, and that the basic principals of good faith and fair dealing cannot be circumvented and negotiated out of an agreement.

Gary A. Goodman is a partner, and Tina Patel is an associate in the real estate practice group of the New York offices of Sonnenschein Nath & Rosenthal LLP.