Commercial Tenants and Landlords Are Free to Negotiate Most Commercial Lease Terms
Commercial leasing differs substantially from residential. While there are often regulations, statutes or local ordinances that protect residential tenants from landlord overreach or substantial rent increases, those protections for commercial tenants are rare or nonexistent. Commercial leases are often negotiated between sophisticated parties, sometimes aided by counsel. Commercial tenants do not suffer the same power imbalance that residential tenants often face when negotiating a lease.
The issue here of whether a 150 percent holdover rent clause is enforceable turned on whether it was a liquidated damages clause (and an unenforceable penalty) or an agreed-on rent if the lease extended beyond a fixed termination date. The court held the provision establishing the holdover rent at 150 percent of the base rent was not an unenforceable penalty.
The Facts of the Case
Constellation-F, LLC, leased warehouse space to World Trading 23, Inc., under a preprinted commercial real estate lease published by AIR Commercial Real Estate. Near the end of the original term, World Trading extended the lease term, but Constellation did not vacate the premises at the end of the extended term. Constellation promptly sued for unlawful detainer, which it converted to a money-damages claim when Constellation voluntarily surrendered the premises.
Constellation sought damages for, among other things, holdover rent of 150 percent of base rent during the holdover period. Following a bench trial, the court found the defendants liable for all damages except for the holdover rent, which the court ruled was an unenforceable penalty.
The California Court of Appeal reversed, finding the holdover rent clause was not an unenforceable penalty but was “a graduated rental.” Parties to a commercial lease may negotiate terms, so long as neither was coerced or there was unequal bargaining power, the court said.
A strong dissent protested, saying the 150-percent holdover rent was a liquidated damages clause, not merely an agreement to pay increased rent. Liquidated damages clauses are unenforceable penalties under California law if they are not a reasonable estimate of the estimated anticipated loss.
Analysis
In California, as in many states, penalty clauses in contracts are prohibited, while liquidated damages clauses are permitted. (see e.g. Cal. Civil Code section 1671 [“a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”].)
California has a well-developed body of authority interpreting this statute. One authority found graduated rentals are not damages. A graduated rental is the rate for leasing property. By its terms Civil Code section 1671 did not apply to a holdover rent provision. (Vucinich v. Gordon (1942) 51 Cal.App.2d 434, 435, 437.)
By defining holdover rent as a “graduated rental,” the court avoided examining whether it was an enforceable liquidated damages clause or an unenforceable penalty clause designed to punish a breach of contract. The court began by assuming the commercial real property leasing market is competitive, in which the parties are “free from obligation to each other” when they entered their lease contract. They were free from coercion when they provided for rental to be paid for the premises after expiration of the definite term, the court said.
Because holdover rent was a statement of the rent due, not “damages” for breach of lease, the liquidated damages statute did not apply. “Graduated rentals are not damages. A graduated rental is the rate for leasing property.” The majority found support in the legislative intent behind Civil Code section 1671 and authorities interpreting it, which “aim to combat unfair and unreasonable coercion arising from an imbalance of bargaining power. … When the concern about oppressive coercion is absent, Civil Code section 1671 does not apply.” Section 1671 puts the burden on the party seeking to invalidate the contractual provision, which, the court held, World Trading did not do here.
The Dissent Saw It Differently
The dissent contends this case contradicted prior California Supreme Court authority interpreting liquidated damages and instead established a “new test by which one may challenge a liquidated damages provision.” Under this new test, “contracting parties need not attempt to tether a liquidated damages provision to estimated anticipated losses; instead a challenger must analyze each contracting party’s respective market power and persuade a court that there was enough of an imbalance of market power between the parties to invalidate the damages provision.”
The dissent observed that under California law, a “‘penalty provision operates to compel performance of an act … and usually becomes effective only in the event of default … upon which a forfeiture is compelled without regard to the damages sustained by the party aggrieved by the breach ….’”
Here, the holdover rent provision was intended to compel performance of a lease term—timely vacating the premises—under threat of a 150-percent holdover rent penalty. Contrary to the majority’s position, the dissent contended the holdover rent was not an agreement to a graduated rent, because the tenant did not have a continuing right to remain in the premises, as evidenced by the landlord’s prompt service of an unlawful detainer action to force World Trade to vacate. The lease itself made clear the landlord was not consenting to allow the tenant to hold over at any amount. When it agreed to extend the lease, Constellation-F already had a buyer to whom it needed to give timely possession of the property. “World Trading did not have the option to choose to stay with Constellation’s blessing after April 1 as long as it paid holdover rent.”
The dissent argued this was evidence the holdover rent was a liquidated damage provision. “To be sure, a liquidated damages provision is not invalid merely because it is intended to encourage a party to perform, so long as it represents a reasonable attempt to anticipate the losses to be suffered.” Here, however, since the trial court found the 150-percent holdover rent did not reflect the anticipated damages, it was an unenforceable penalty, a factual determination that should not be disturbed on appeal.
Trial testimony established the true purpose of the holdover rent provision in the preprinted AIR Commercial Lease Form was to “provide a disincentive to the tenant to remain in possession past the lease expiration, and provide a reasonable estimate of the landlord’s damages and risks should that tenant holdover.” “Thus we face a uniform holdover rent provision of 150 percent of the base rent on this pre-printed lease. It is based not on what the parties to this particular lease might have estimated to be holdover damages, but on what [the AIR lease-drafting committee] concluded was reasonable and would ‘work’ in the industry as a whole.”
The dissent would hold California authority mandates that a reasonable effort be made by the parties to a commercial lease to estimate the anticipated damages if a breach occurs.
Conclusion
This decision turns on whether the 150-percent holdover rent is a graduated rent, as the majority found, or whether it is an unenforceable penalty clause, designed to punish a breaching party. For the moment, California authority finds the 150 percent holdover clause to not be an unenforceable penalty clause. Given the strong dissent, and apparent diversion from Supreme Court authority, this decision may be depublished or taken up for consideration by the Supreme Court.