Liquidated Damages Clause Found to be Unenforceable Penalty

On November 24, 2020, the Court of Appeals issued a decision in Trustees of Columbia Univ. in the City of N.Y. v. D'Agostino Supermarkets, Inc., 2020 NY Slip Op. 06937, finding a liquidated damages clause to be an unenforceable penalty, explaining:

In accordance with the parties' commercial tenancy, in the event of a breach, plaintiff had two options: (1) allow defendant to maintain possession of the property for the full lease term and hold defendant liable for past and future rent, or (2) reenter the premises and collect all rent due up to the time of reentry. If it chose to reenter, plaintiff could relet the premises and defendant would be liable for any deficiency in rent and other related expenses. Instead of suing for a breach of the lease, the parties negotiated and entered into the Surrender Agreement, which provided that, on the date of surrender, the lease and the term thereof and all rights of defendant thereunder shall expire and terminate. It further relieved defendant of its obligations under the lease, including payment of future rent and costs, in exchange for defendant's payments of certain fixed amounts totaling $261,751.73 and its surrender of the premises to plaintiff.

In other words, and as is commonly understood of these arrangements, the Surrender Agreement constituted a new contract between the parties that terminated the lease and all prospective obligations flowing from the tenancy. This new contract also included a liquidated damages provision. Liquidated damages are an estimate, made by the parties at the time they enter into their agreement, of the extent of the injury that would be sustained as a result of breach of the agreement. A liquidated damage provision has its basis in the principle of just compensation for loss. Liquidated damages that constitute a penalty, however, violate public policy, and are unenforceable. A provision which requires damages grossly disproportionate to the amount of actual damages provides for a penalty and is unenforceable.

Defendant, as the party seeking to avoid payment of liquidated damages, has the burden of establishing that the damages for breach of the Surrender Agreement were disproportionate to the foreseeable losses and in fact, a penalty. Defendant met that burden.

The question here distills to whether the liquidated damages provision in the Surrender Agreement is so disproportionate to the anticipated harm to plaintiff from defendant's failure to timely pay the monthly installments that the provision constitutes a penalty. The damages provision effectively reinstated defendant's future rent liabilities under the terminated lease, to the tune of $1,020,125.15, plus interest and other prospective taxes and costs due under the lease, even though those damages did not flow from a breach of the Surrender Agreement. Those damages were 7½ times what plaintiff would have received, if defendant had fully complied with the Surrender Agreement. Plaintiff cannot enforce a non-existent lease under the guise of damages for a breach of a separate contract.

To be clear, when the lease was in effect, plaintiff could have exercised its rights as the landowner and proceeded against defendant for violating the leasehold terms. Instead, plaintiff negotiated with defendant to terminate the lease in exchange for a set amount of money and surrender of the premises. That contract freed plaintiff from its lessor obligations. Critically, contrary to the dissent's assertion that plaintiff received nothing in exchange, it allowed plaintiff to immediately reenter and relet the premises without the need for litigation, which is exactly what it did.

When defendant breached the Surrender Agreement, plaintiff was entitled to proceed under that contract and demand damages for the breach, including the amount past due and acceleration of the remaining installment payments. However, plaintiff could not seek a payment grossly disproportionate to the amount past due plus interest.

A simple hypothetical further illustrates the penalizing nature of the liquidated damages provision here. According to plaintiff's interpretation of the Surrender Agreement, if defendant timely made all but the final monthly surrender payment of $15,977.43, defendant's breach would render it liable for $1,029,969.54 plus interest and additional costs. Defendant would be liable for the total amount remaining due under the terminated lease, and defendant would be forced to pay that amount, rather than the final installment, without having had the benefit of the premises which it had surrendered to plaintiff. There is but one way to refer to this outcome: an unenforceable penalty.

Our decision in Van Duzer is instructive. In that appeal, the defendants maintained that the landowner's acceleration of prospective rent was disproportionate to the landowner's actual damages where the landowner terminated the lease and relet the premises after the tenant vacated. Without deciding whether the amount sought was a penalty, we held that the defendants were entitled to a hearing to present evidence that the undiscounted accelerated rent was disproportionate to the landowner's actual losses, and thus constituted unenforceable liquidated damages. As we explained,

arguably the ability to obtain all future rent due in one lump sum, undiscounted to present-day value, and also enjoy uninterrupted possession of the property provides the landowner with more than the compensation attendant to the losses from the breach—even though such compensation is the recognized purpose of a liquidated damages provision.

The facts in this appeal present an even more obvious case of an unenforceable penalty. In Van Duzer, the landowner proceeded under the lease for damages flowing directly from the tenant's abandonment of the premises and noncompliance with the lease terms. Again, the payment plan in the Surrender Agreement here reflects the parties' negotiated damages for the breach of the lease, not the Surrender Agreement. The subsequent failure to pay installments on time is a breach of the Surrender Agreement, and a breach that is properly compensated by an award of the outstanding settlement payments plus interest.

The dissent maintains that the Surrender Agreement is best understood as a settlement agreement. Why this would matter is unclear considering that a settlement agreement, like any other agreement, cannot be enforced if it violates public policy, including our state's rejection of penalties as damages.

Plaintiff unpersuasively argues and the dissent agrees that affirmance here would disincentivize landowners from entering surrender agreements and deprive tenants of the benefit afforded by such arrangements. Plaintiff chose to terminate the lease in exchange for a fixed amount paid in installments and reentry on the premises for purposes of entering a new lease with another tenant. The award of outstanding payments therefore allowed plaintiff to realize the benefit of its bargain under the Surrender Agreement and put the property to its highest and best use. This approach encourages surrender agreements as providing a benefit to all parties—the tenant is released from future liability and the landowner regains the premises and the opportunity to relet on its own account. In contrast, the dissent's approach would disincentivize tenants from negotiating a mutually agreeable surrender because the tenant would remain on the hook for back rent, future rent and other contractual damages without the benefit of enjoyment of the premises.

Plaintiff's real argument is that it did not receive six payments on time, but that was the risk that it accepted by entering the Surrender Agreement. A party's default is a risk common to all contracts, without unique effect in the context of a surrender of premises. And the existence of that risk does not and cannot justify exaction of a penalty.

. . .

Under our well-established rules of contract, the Surrender Agreement's liquidated damages provision does not fairly compensate plaintiff for defendant's delayed installment payments. The provision calls for a sum more than sevenfold the amount due if defendant had complied fully with the Surrender Agreement. We cannot enforce such an obviously and grossly disproportionate award without offending our State's public policy against the imposition of penalties or forfeitures for which there is no statutory authority. Accordingly, there was no error in rejecting plaintiff's liquidated damages provision.

(Internal quotations and citations omitted).

A key element in commercial litigation is proving damages. As this decision shows, agreeing beforehand on the damages that will result from a breach of contract does not always result in an enforceable agreement. Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client have questions regarding proving damages.