Acceleration of Rents

Acceleration of rent provisions comes in all shapes and sizes in landlords' form leases. The most onerous for a tenant requires the full acceleration of all future rent and other charges due under the lease. Other varieties provide that the amount to be accelerated is calculated only after first deducting the fair market rental value of the premises over the remaining term. Even better for a tenant is the rent acceleration clause that further reduces the future rent to its net present value.

Accelerating all future rent is a severe consequence to a tenant, so courts have closely scrutinized such provisions and taken varying positions on their enforceability and validity. Interestingly, whether or not a particular state finds such provisions to be enforceable can relate to whether or not such states have moved away from the old common-law perspective of treating leases as a conveyance of real property and instead take the modern approach of treating leases as commercial contracts. Normally, the movement toward contract theory favors the tenant, but contract principles of liquidated damages can offer landlords an enforceable remedy not found under the old common law.

Massachusetts

Such was the case in a 2007 Massachusetts decision. In Cummings Properties, LLC v. National Communications Corp. (449 Mass. 490), the Massachusetts Supreme Judicial Court ruled that a liquidated damages clause in a commercial lease, providing for a full acceleration of future rent after a default by tenant, was enforceable. The ruling was a departure from the established law in Massachusetts, explained in the opinion as part of a trend toward enforcing liquidated damage clauses in commercial contracts. The holding also indicated that the acceleration clause was presumed to apply only to those material breaches such as monetary defaults. While many other states interpret the application of the acceleration clause in light of a landlord's duty to mitigate damages, the Massachusetts decision apparently finds that the duty to mitigate is not relevant. Instead, the critical factor is whether the lump-sum amount chosen by the sophisticated commercial parties is a reasonable estimate of the damages that might be sustained after the tenant's default, with the burden on the tenant to demonstrate that such a clause fails to take properly into account future conditions.

Other States

Other states have held acceleration of rent clauses to be unenforceable because they constitute penalties, giving the landlord a potential windfall recovery much greater than its true loss suffered, even after very minor breaches by the tenant. Such was the basis for the decision in the 1953 California case of Ricker v. Romborugh (261 P.2d 328).

The majority of states, however, have taken a more nuanced view, reviewing the facts and circumstances of the particular case instead of giving a blanket per se thumbs up or thumbs down to rent acceleration. If the acceleration clause is styled as a liquidated damages provision, the clause is often presumed enforceable provided it does constitute a penalty. For example, in a 1996 case before a Virginia Circuit Court, The Teachers Retirement System of the State of Illinois v. American Title Guaranty Corporation (1996 WL 1065475), the court took into account several factors in holding that an agreement that provides for liquidated damages grossly in excess of actual damages will be deemed an unenforceable penalty.

The factors considered in the opinion included the lack of a provision either discounting future rents to present value or providing for future credits or offsets back to tenant if the landlord eventually relets the premises. Similarly, under current Georgia law, that state's courts apply a three-part test defined by the Georgia Court of Appeals in the 1992 case, Peterson v. P.C. Towers, L.P. (206 Ga. App. 591). In determining that an acceleration of rents clause qualifies as enforceable liquidated damages instead of an unenforceable penalty, the Georgia decision held that the acceleration of rents clause satisfied the following three conditions: 1) the injury from the tenant's breach must be difficult or impossible to accurately estimate; 2) the parties intend to provide for damages, rather than for a penalty; and 3) the stipulated lump sum payment is a reasonable estimate of the probable loss to be incurred.

The Supreme Court of Pennsylvania took a much different approach in its 1995 decision, Homart Development Co. v. Sgrenci (443 Pa. Super. Court 538), rejecting a liquidated damages analysis in favor of a more traditional view based upon real property law. The court held that the landlord could not confess judgment for both possession of the premises and for all rent for the entire term, instead deciding that the landlord had to choose one remedy.'

Approaches to Take

After first taking into account the laws of the applicable jurisdiction, the landlord needs to review the proposed acceleration of rents provision carefully to verify its enforceability under such law. Revising a potentially unenforceable clause to a simple and more reasonable approach could be beneficial to all parties. There are many approaches to consider in drafting a more reasonable acceleration of rents provision. From the landlord's perspective, including a more balanced clause in the initial form lease could lessen the risk of a court's finding the provision unenforceable. Such an approach could also perhaps save negotiation time and expense, while still preserving the flexibility and certainty that accelerated damages provides. From the tenant's perspective, a true accelerated monetary judgment would be disastrous if held to be enforceable, so any reasonable compromises should be welcome. Like everything else, leverage is often the deciding factor. The larger credit-worthy tenants will have more negotiating leverage and will be in a better position to resist unreasonable landlord remedies.

Compromises

The first suggested compromise would be to have the accelerated rent provision apply only to the most serious of defaults or only in the event of the tenant's bankruptcy. Many of the decisions reviewed focus on the potential unfair results of accelerating rents after the most trivial of defaults.

Second, the amount to be accelerated could either be net of the fair market rental value (with fair market value determined through a reasonable good-faith process) instead of based upon the entire amount payable for the remainder of the term, or net of the amounts a landlord could reasonably or does actually gain from any reletting. If determined after any relettings, then there must be a mechanism to credit such offsets back to the tenant.

Third, the amount accelerated could be calculated as the net present value of such future rental stream. Provisions that give landlords the right to recover a straight-line depreciated value of all future rents may be received by courts as providing an unjust and unconscionable windfall and result in no future damages being awarded. This is especially true if the term of the lease is lengthy.

Last, if the parties agree to a net present value concept, then the discount rate used in such calculation should be a commercially reasonable one. Note that the lower the discount rate used, the higher the net present value. Many unsuspecting or unsophisticated tenants think they are getting a fair deal when offered the net present value compromise, only to agree to an interest rate at or below the Federal Reserve rate. Or alternatively, some national tenants confuse the landlord by offering the high interest rate used in the lease as the “default rate” as the discount rate used to calculate the net present value. A middle ground would be preferable to both parties.

Conclusion

When negotiating and drafting a commercial lease, the landlord's remedies after a default by tenant require careful scrutiny. The amount at stake is considerable and the results to either party can be severe. The parties need to be very familiar with the applicable state law, given the vast differences among the states with respect to the remedies provided the commercial landlord. With respect to accelerated rent provisions, courts typically find such clauses to be unenforceable to the extent they offer the commercial landlord the chance to collect damages in excess of probable damages that truly will result from the tenant's default. To draft a clause that will survive scrutiny, it is best to discount the future rental payments to present value and take into account the landlord's duty to mitigate damages by attempting to relet the premises. Above all, the amount accelerated must not constitute a penalty.

John G. Kelly, a member of this newsletter's Board of Editors, is a partner with Bean Kinney & Korman in Arlington, VA. His commercial leasing practice includes representing both Washington, DC, area landlords and national tenants in office, retail, government and industrial leases. He can be reached at [email protected].

An acceleration of rent provision gives the landlord the right, after a default by the tenant, to demand the entire balance of the unpaid rent owed under the lease for the entire remainder of the term to be paid in one lump sum. Under the law of most states, if there is no acceleration of rents provision, the landlord is typically entitled only to collect rent from the tenant as it becomes due under the lease each month for the remainder of the term. In many states, the landlord's remedy would be further subject to a duty to mitigate damages by making efforts to find a replacement tenant for the vacated premises.

Although requiring the landlord to collect rent each month from the defaulting (and former) tenant provides some degree of certainty, it is often impractical for a multitude of reasons, and the landlord would clearly prefer to collect the balance of the rent owed under the lease for the remainder of the term in one payment. Accordingly, most landlords include an acceleration clause in their form commercial lease. Whether or not such a provision is enforceable depends on the laws of the particular state and the facts of the case. This article highlights some recent court decisions on the topic, and offers some suggestions for reasonable middle ground positions that should survive scrutiny.

Factors to Consider

Acceleration of rent provisions comes in all shapes and sizes in landlords' form leases. The most onerous for a tenant requires the full acceleration of all future rent and other charges due under the lease. Other varieties provide that the amount to be accelerated is calculated only after first deducting the fair market rental value of the premises over the remaining term. Even better for a tenant is the rent acceleration clause that further reduces the future rent to its net present value.

Accelerating all future rent is a severe consequence to a tenant, so courts have closely scrutinized such provisions and taken varying positions on their enforceability and validity. Interestingly, whether or not a particular state finds such provisions to be enforceable can relate to whether or not such states have moved away from the old common-law perspective of treating leases as a conveyance of real property and instead take the modern approach of treating leases as commercial contracts. Normally, the movement toward contract theory favors the tenant, but contract principles of liquidated damages can offer landlords an enforceable remedy not found under the old common law.

Massachusetts

Such was the case in a 2007 Massachusetts decision. In Cummings Properties, LLC v. National Communications Corp. (449 Mass. 490), the Massachusetts Supreme Judicial Court ruled that a liquidated damages clause in a commercial lease, providing for a full acceleration of future rent after a default by tenant, was enforceable. The ruling was a departure from the established law in Massachusetts, explained in the opinion as part of a trend toward enforcing liquidated damage clauses in commercial contracts. The holding also indicated that the acceleration clause was presumed to apply only to those material breaches such as monetary defaults. While many other states interpret the application of the acceleration clause in light of a landlord's duty to mitigate damages, the Massachusetts decision apparently finds that the duty to mitigate is not relevant. Instead, the critical factor is whether the lump-sum amount chosen by the sophisticated commercial parties is a reasonable estimate of the damages that might be sustained after the tenant's default, with the burden on the tenant to demonstrate that such a clause fails to take properly into account future conditions.

Other States

Other states have held acceleration of rent clauses to be unenforceable because they constitute penalties, giving the landlord a potential windfall recovery much greater than its true loss suffered, even after very minor breaches by the tenant. Such was the basis for the decision in the 1953 California case of Ricker v. Romborugh (261 P.2d 328).

The majority of states, however, have taken a more nuanced view, reviewing the facts and circumstances of the particular case instead of giving a blanket per se thumbs up or thumbs down to rent acceleration. If the acceleration clause is styled as a liquidated damages provision, the clause is often presumed enforceable provided it does constitute a penalty. For example, in a 1996 case before a Virginia Circuit Court, The Teachers Retirement System of the State of Illinois v. American Title Guaranty Corporation (1996 WL 1065475), the court took into account several factors in holding that an agreement that provides for liquidated damages grossly in excess of actual damages will be deemed an unenforceable penalty.

The factors considered in the opinion included the lack of a provision either discounting future rents to present value or providing for future credits or offsets back to tenant if the landlord eventually relets the premises. Similarly, under current Georgia law, that state's courts apply a three-part test defined by the Georgia Court of Appeals in the 1992 case, Peterson v. P.C. Towers, L.P. (206 Ga. App. 591). In determining that an acceleration of rents clause qualifies as enforceable liquidated damages instead of an unenforceable penalty, the Georgia decision held that the acceleration of rents clause satisfied the following three conditions: 1) the injury from the tenant's breach must be difficult or impossible to accurately estimate; 2) the parties intend to provide for damages, rather than for a penalty; and 3) the stipulated lump sum payment is a reasonable estimate of the probable loss to be incurred.

The Supreme Court of Pennsylvania took a much different approach in its 1995 decision, Homart Development Co. v. Sgrenci (443 Pa. Super. Court 538), rejecting a liquidated damages analysis in favor of a more traditional view based upon real property law. The court held that the landlord could not confess judgment for both possession of the premises and for all rent for the entire term, instead deciding that the landlord had to choose one remedy.'

Approaches to Take

After first taking into account the laws of the applicable jurisdiction, the landlord needs to review the proposed acceleration of rents provision carefully to verify its enforceability under such law. Revising a potentially unenforceable clause to a simple and more reasonable approach could be beneficial to all parties. There are many approaches to consider in drafting a more reasonable acceleration of rents provision. From the landlord's perspective, including a more balanced clause in the initial form lease could lessen the risk of a court's finding the provision unenforceable. Such an approach could also perhaps save negotiation time and expense, while still preserving the flexibility and certainty that accelerated damages provides. From the tenant's perspective, a true accelerated monetary judgment would be disastrous if held to be enforceable, so any reasonable compromises should be welcome. Like everything else, leverage is often the deciding factor. The larger credit-worthy tenants will have more negotiating leverage and will be in a better position to resist unreasonable landlord remedies.

Compromises

The first suggested compromise would be to have the accelerated rent provision apply only to the most serious of defaults or only in the event of the tenant's bankruptcy. Many of the decisions reviewed focus on the potential unfair results of accelerating rents after the most trivial of defaults.

Second, the amount to be accelerated could either be net of the fair market rental value (with fair market value determined through a reasonable good-faith process) instead of based upon the entire amount payable for the remainder of the term, or net of the amounts a landlord could reasonably or does actually gain from any reletting. If determined after any relettings, then there must be a mechanism to credit such offsets back to the tenant.

Third, the amount accelerated could be calculated as the net present value of such future rental stream. Provisions that give landlords the right to recover a straight-line depreciated value of all future rents may be received by courts as providing an unjust and unconscionable windfall and result in no future damages being awarded. This is especially true if the term of the lease is lengthy.

Last, if the parties agree to a net present value concept, then the discount rate used in such calculation should be a commercially reasonable one. Note that the lower the discount rate used, the higher the net present value. Many unsuspecting or unsophisticated tenants think they are getting a fair deal when offered the net present value compromise, only to agree to an interest rate at or below the Federal Reserve rate. Or alternatively, some national tenants confuse the landlord by offering the high interest rate used in the lease as the “default rate” as the discount rate used to calculate the net present value. A middle ground would be preferable to both parties.

Conclusion

When negotiating and drafting a commercial lease, the landlord's remedies after a default by tenant require careful scrutiny. The amount at stake is considerable and the results to either party can be severe. The parties need to be very familiar with the applicable state law, given the vast differences among the states with respect to the remedies provided the commercial landlord. With respect to accelerated rent provisions, courts typically find such clauses to be unenforceable to the extent they offer the commercial landlord the chance to collect damages in excess of probable damages that truly will result from the tenant's default. To draft a clause that will survive scrutiny, it is best to discount the future rental payments to present value and take into account the landlord's duty to mitigate damages by attempting to relet the premises. Above all, the amount accelerated must not constitute a penalty.

John G. Kelly, a member of this newsletter's Board of Editors, is a partner with Bean Kinney & Korman in Arlington, VA. His commercial leasing practice includes representing both Washington, DC, area landlords and national tenants in office, retail, government and industrial leases. He can be reached at [email protected].