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Liquidated damages: not a watered down remedy.

The typical remedy for terminating a lease is not to dissuade a tenant from defaulting under certain lease obligations. Giving the tenant a 15-day grace period, before the landlord may terminate the lease, if the tenant fails to open its store by the date specified in the lease (outside date), will not insure that the tenant will open its store by the outside date. In fact, it probably will have the opposite effect as the tenant may simply build into its fixturing period the additional 15-day grace period.

Further, what manager would terminate a credit tenant lease when the tenant is as much as two months behind schedule in construction? Both the cost of negotiating with another tenant and the time delay for the other tenant to open for business and start to pay rent, would far exceed the direct and indirect cost to the owner of the original tenant's two-month delay. This is particularly true if the credit tenant is required to start paying rent on the outside date, regardless of whether it is open for business.

However, the commencement of the rent payments by the tenant may not compensate the landlord for all of its direct and indirect damages. If the tenant is a key or anchor tenant in a new strip shopping center, a delay in opening may detract from the grand opening promotions already scheduled.

Further, this delay may adversely affect the customer traffic at the shopping center, causing low sales at other stores, which are dependent on the anchor store being open for business; delay the public's perception of the center as a destination shopping center in a highly competitive (if not overbuilt) market; and impede further leasing activity.

While the landlord could always sue the tenant for its actual damages if this occurred, such direct and indirect damages may be difficult for the landlord to prove in court. These are the damages which are the so-called "difficult or impossible damages to determine" for which the remedy of liquidated damages is particularly suited.

Liquidated damages defined

"Liquidated damages" is the legal term for the agreement by ownership to waive its other default remedies, where the damages caused by a tenant default may be difficult or impossible to determine the advance. In return the tenant agrees to pay the owner an agreed upon sum.

In our example above, the tenant might agree to pay the owner, as liquidated damages, and in addition to the minimum rent payable under the lease, an amount equal to 50 percent of the per diem minimum rent payable under the lease for each day after the outside date that the tenant's store is not open.

The prospect of liquidated damages, which are intended to compensate the landlord for what the landlord and the tenant reasonably estimate would be the landlord's damages in the event of a specified tenant default, has the added benefit of giving the landlord additional leverage on a tenant to induce performance. It is an added benefit because by definition, liquidated damages is not a specific performance remedy. However, it is this byproduct--the added leverage to induce the tenant to specifically perform in order to avoid the payment of the liquidated damages sum--which is most appealing to landlords.

Pitfalls

There are three important pitfalls which must be overcome in drafting an enforceable liquidated damages provisions. First, the liquidated damages remedy must be the exclusive remedy available to the owner for a default. The landlord cannot reserve the right to choose between liquidated damages and other remedies under the lease at the time of the default. Such an election would defeat the intent of liquidated damages as an agreement in advance of what the landlord's damages will be in a situation where it is difficult or impossible to determine damages.

Second, the amount of liquidated damages must be reasonable. Otherwise, courts will rule that the liquidated damages specified in the lease are a penalty and that the provision is unenforceable. The term "reasonable" has been interpreted to mean "reasonable under the circumstances" and, as a consequence, is subject of debate and is dependent on the facts of each case.

For example, a lease preventing a tenant from opening another store within two miles of the leased premises and providing that if the tenant did so in spite of the prohibition, then 100 percent of the gross sales at the other store would be included as gross sales from the leased premises for purposes of calculating percentage rent, may be an unreasonable and therefore unenforceable liquidated damages clause.

It is unlikely that 100 percent of the sales from the other store would have been generated at the leased premises. But how would a court rule if the percentage had been 50 percent, 35 percent, or 20 percent?

In addition, when must the amount be reasonable--at the time the landlord and tenant execute the lease, or at the time of the tenant's default or at both times? Unfortunately, the law and the courts have not been entirely clear on this timing issue. However, some general rules may be discerned.

In all cases, liquidated damages must be a reasonable approximation of the landlord's actual damages at the time landlord and tenant signed the lease.

Depending upon the court and state, a court may also look to see whether the liquidated damages are reasonable at the time of the breach. In such cases, the court compares the amount of liquidated damages specified in the lease to the actual damages proved by the owner in court. If the difference is substantial, the court may invoke its equitable powers and reduce the liquidated damages amount to the actual damages.

Third, liquidated damages are an enforceable remedy only where actual damages are difficult or impossible to calculate. Thus, liquidated damages should have a limited role in a lease and cannot be applied to every default situation. Consequently, failure to provide a gross sales statement or tenant's failure to provide annual inspection reports on the HVAC system could not be enforced by use of liquidated damages.

Use of liquidated damages

I advocate the use of liquidated damages in three important provisions in the lease:

* a tenant's failure to open for business by the outside date,

* a failure to continuously operate the premises throughout the term during specified days and hours, and

* a tenant's breach of its covenant not to open a competing store within an agreed upon distance from the leased premises.

All three of these situations are instances in which actual damages may be difficult to prove, but which may cause real harm to the owner and the shopping center. Further, all three situations are ones in which the landlord wants added leverage on the tenant to induce performance. This added leverage is particularly important because courts have been reluctant to grant landlords specific performance to remedy these defaults.

The following model-form language would be appropriate for use as a liquidated damages provision in the situations described in the first two preceding provisions.

Tenant shall, subject to "force majeure events", (1) open the leased premises by the outside date and thereafter continuously operate all of the leased premises in good faith during the term with due diligence and efficiency so as to produce the maximum profitable and practical gross sales which may be produced by such manner of operation; (2) carry a reasonably complete stock of merchandise and shall maintain reasonably adequate personnel for efficiently accommodating its customers and (3) keep the leased premises open for business each day during such hours and days as Landlord shall (in Landlord's sole discretion) designate.

If Tenant defaults in respect to any of the foregoing covenants, then, as Landlord's sole and exclusive remedy on account thereof, Tenant shall, in recognition of the difficulty or impossibility of determining Landlord's damages, pay to the Landlord, upon demand, as liquidated damages (and not as a penalty) and in addition to the minimum rent and other charges payable under this Lease, a separate charge equal to 1/60 of the then applicable monthly minimum rent for each day, or part thereof, Tenant fails to open or operate the leased premises in accordance with the provisions of this Section.

As we have seen, liquidated damages are a useful landlord tool for inducing tenant performance under a lease, but must be skillfully drafted to avoid any of the pitfalls which may lead a court to hold such a provision unenforceable. Mark D. Eisemann is a partner at Lewis, Rice & Fingersh, specializing in shopping center development and leasing. He practices in the firm's real estate department in the Overland Park, Kansas office.
COPYRIGHT 1991 National Association of Realtors
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Eisemann, Mark D.
Publication:Journal of Property Management
Date:Jul 1, 1991
Words:1436
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