A Million Dollar Lease Drafting Lesson

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An “Evergreen” contract is one that renews over and over. So does an “Evergreen” letter of credit. So does the topic that follows – how, if your documents are not written carefully, courts may do damage. And, perhaps “written” isn’t the real activity to be scrutinized and “thought-through” would be a better choice of words.

Today, we are going to look at a late April court decision from the U.S. District Court for the Southern District of New York: In re: The Great Atlantic & Pacific Tea Company, Inc. You can see it by clicking HERE.

This is about A&P’s bankruptcy and even without knowing the disputed issue, a very good guess is that the bankrupt estate will be enhanced by the court’s ruling. If that is a little cynical on the part of Ruminations, then so be it. While there are conflicting public policies involved in bankruptcy matters, one seems to loom over almost all others: “get more money into the pot to pay unsecured creditors.”

Read on; look at the decision itself; you decide.

We’re going to try to stay within the lines, remembering that our goal is to focus on an old rubric of ours, “words matter – say what you mean and mean what you say.” Today’s posting is not bent on arguing with public policy or “proving” that some “justice” can be result-oriented.

To start, we’ve got to get on the same page as to two definitions. The court referred to them, and we’ll go to the court’s source, Black’s Law Dictionary (Seventh Edition). The first word is “abate” and Black’s tells us that the “abatement” means: “The act of eliminating or nullifying” or “The act of lessening or moderating; diminution in amount or degree.” [In this case, the court only cited the first definition. Keep that in mind.]

The other word is “forfeiture.” Here, Black’s defines that to mean: “The divestiture of property without compensation” or as “The loss of a right, privilege, or property because of a crime, breach of obligation, or neglect of duty” or as “Something (esp. money or property) lost or confiscated by this process; a penalty” or “A destruction or deprivation of some estate or right because of the failure to perform some obligation or condition contained in a contract.” [In this case, the court liked the one that mentions a crime. Pointedly, it didn’t use the one that mentioned a penalty. Keep that in mind as well.]

We also feel compelled to give readers one more “tool” for understanding what follows. Here it is.

There is an important, authoritative legal reference known as the Restatement (Second) of Contracts. One of the legal principles it summarizes [in its Sec. 356 (1) (1981)] tells us that: “Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.” Such penalties are unenforceable.

Basically, applying this principle leads to a twofold question; first, whether the agreed-upon damages are reasonably related to the anticipated or actual damage likely to be suffered and, second, whether those damages are unascertainable or difficult to prove, resulting in the inconvenience or non-feasibility of otherwise obtaining a remedy.

Now to a story.

Under its lease, a supermarket operator agreed to construct its own building even though it was only a tenant. In return, its landlord agreed to pay the tenant a “Construction Allowance” of about two million dollars in accordance with this critically worded lease provision, edited for clarity:

The landlord “shall pay to [tenant]” a $1.9 million Construction Allowance on or before the ninetieth day following the date that tenant opened its store to the public. “If [the landlord] fails to pay” the Construction Allowance to the tenant, then the tenant’s “obligation to pay fixed annual rent and Charges shall abate … until [the tenant’s] receipt of the Construction Allowance, together with interest on the unpaid balance thereof at the Lease Interest Rate… .”

So as not to keep you in suspense, for what may have been a good reason (to many but the court), the construction allowance was not paid within those ninety days. The tenant filed for bankruptcy before the end of the ninety days. That held up a loan the landlord had arranged from its lender. The allowance was paid shortly after the tenant affirmed the lease (i.e., agreed that it would not reject the lease in its bankruptcy). That was ten months after the end of the ninety day period.

The tenant withheld rent and tax payments for those ten months and the bottom line result of the court’s decision was that the tenant never, ever has to pay about one million dollars of rent and other charges to its landlord because the landlord took ten months to pay the construction allowance and the interest thereon.

What allowed the court to “tag” the landlord with a one million dollar loss? Ruminations thinks it was the “far less than clear” lease drafting. It’s not that we don’t think the lease couldn’t easily have been interpreted to require the tenant to pay the ten months of rent and taxes. It is that the way the lease was written, it was possible to reach the same result as the court reached even though common sense should tell anybody that the landlord could never have “agreed” to lose one million dollars if it didn’t pay the construction allowance within ninety days.

Are we saying that there shouldn’t have been any consequences to the landlord if it didn’t pay the construction allowance on time? “No.” The lease actually contemplated some other consequences and afforded the tenant some protection. First, the tenant’s loss of use of the money was tempered by the interest paid to it by its landlord. Second, it had use of the withheld rent and taxes without the need to pay interest to its landlord. Third, as with other moneys it might ever be owed by its landlord, the tenant had the right to offset the unpaid construction allowance against rent and other charges. In fact, whereas every other possible rent offset was restricted to 30% of the rent payable at any time, an offset on account of the unpaid construction allowance was not restrained by such a limit.

How did the court get there? It’s simple. It latched onto the word “abate,” a word the landlord allowed into the lease and now has a million reasons to regret doing so. Abate does not mean the same thing as suspend. And while it is true that court after court repeat the mantra about reading contracts (and leases) to find what the parties “intended” and to read the “simple” meaning into the words used, losing parties don’t always think that courts get that “right.”

By looking at the inapplicability of the lease’s 30% limit on rents offsets to unpaid amounts of the construction allowance, we can see that the landlord and tenant were thinking that offset was the agreed-upon remedy for such non-payment. If they had really agreed that the rent otherwise payable during the delay would never have to be paid, they wouldn’t have specifically “carved” the construction allowance out of the 30% limit. What they didn’t think through, however, was that there could be no “application” of the offset right to rents that didn’t have to be paid while the rent and tax payments were “abated” (regardless of whether “abate” meant forever or just a “suspension”). That’s a further indication of sloppy drafting.

Now, Ruminations wouldn’t have a problem with the definition of “abatement” cherry picked by the court – the “act of eliminating or nullifying” – even though it could have chosen the “act of lessening or moderating; diminution in amount or degree” IF the court had focused on WHAT was to be abated. The lease said that the tenant’s “obligation to pay fixed annual rent and Charges shall abate… until” the allowance was paid. [The underlining is ours.] It did not say that the “annual fixed rent and Charges” would abate. To us, even if the obligation was “eliminated or nullified” until the construction allowance was actually paid, it would have been revived once the allowance was paid and the tenant was clearly obligated, under the lease, to pay rent and taxes. We think the court could have made that distinction. But, it didn’t.

Courts, not Ruminations, have the last word on these questions. Maybe, a higher court will see it as we see it. There is no guaranty of that result. And, we concede that the landlord gave the court an articulable basis, if not the best basis, to reach its expensive conclusion. The landlord gave the court a conical or rectangular metal object containing 5 or 6 pounds of gunpowder to use in blowing up the landlord’s expectations of getting paid.

That’s the “say what you mean, mean what you say” portion of today’s posting. If you’d like to see some other posts where we’ve also said that, try clicking one or more of these: HERE or HERE or HERE or HERE or HERE or HERE.

Now for those who seek “gratification gained from pain, deprivation, degradation, etc., inflicted or imposed on oneself, either as a result of one’s own actions or the actions of others,” the definition we (not the court) have chosen for the word “masochist,” here’s why we’ve also told you about liquidated damages and about forfeiture.

Assuming that the court’s interpretation of the lease was correct (and, by definition, unless and until a “higher” court says otherwise, it IS correct), does any reader think the landlord was penalized (by $1,000,000) for missing the ninety day point? Let’s assume there is at least one such reader. That allows us to proceed and explain why the court didn’t care.

What were the tenant’s damages resulting from the landlord’s late payment by ten months. Was its occupancy or possession disturbed? – “No.” Did it lose the use of the money? – “Maybe”: it did get interest and it could hold onto what would have been rent and tax payments. Did it “lose” the building to the landlord? “No,” because there was a lease provision we didn’t tell readers yet, was that the lease “deemed” the building to be “owned” by the tenant until it got paid.

Harking back to the law of permissible “liquidated damages” and whether agreed-upon damages described in a lease are enforceable or will be construed to be an “unenforceable penalty,” one needs to ask if the agreed-upon damages in this particular lease were in “an amount that [was] reasonable in light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss” at the time the lease was signed.

We’ll leave that to each reader to decide for herself or himself.

For those readers who think a million dollars is an unwarranted loss to a landlord who actually did pay the construction allowance, though ten months late, and paid it with interest while the tenant was able to use the withheld “rent” money, here’s how the court felt comfortable with such a result. It said it was a “forfeiture” and not a penalty and wasn’t an award of damages. Basically, to this court, it was just a business term, a contractual outcome of an “if-then” lease provision.

Was the word “forfeiture” or any synonym found in the lease? No. Did that matter to the court? No.

What the court did was to look at a case where a franchisee lost its license when it defaulted under its franchise agreement and at another case where a tenant lost its option right to purchase the property when it failed to send the required notice. Basically, it liked this statement by the New Jersey Supreme Court in the franchise case: “[I]f parties choose to contract for a forfeiture, a court of equity will not interfere with that contract term in the absence of fraud, accident, surprise, or improper practice.” Basically, the court was saying that equity will not be applied where there is a contractual remedy at law. To Ruminations, it seems the court could have found a whole bunch of other cases where principles of equity have been used to temper the harsh results that would have come out of a minor breach of a clear contractual obligation. But, it didn’t.

If the court wanted to find a basis to “interfere” with what it ultimately decided (i.e., to give the tenant a million dollar windfall), it had plenty of basis, beginning with impracticality of performance given that the delay was directly related to the bankruptcy filing. The filing took place four days before the landlord’s loan closing date. The loan was for the purpose of paying the construction allowance. As soon as the tenant affirmed its lease, the closing took place and the tenant was paid.

So, if contractually agreed-upon damages are subject to an “equitable” analysis, which is the kind of analysis applied to “liquidated damages,” shouldn’t forfeiture, often a more draconian remedy, be similarly analyzed? “No,” not according to this court. It rejected all of the landlord’s arguments to that effect. What were those arguments? Summed up, they were that payment of the construction allowance was merely delayed and that “forfeiture would be ‘unconscionable and unjust’ because [the tenant] had been compensated for [its landlord’s] breach through [the landlord’s] interest payments.” The landlord offered several cases in support of its argument, one of which seemed pretty close to being “on point.” The court, however, rejected the holding in that 1917 New Jersey case where a court rejected the “forfeiture.” Its explanation was that no New Jersey cases had cited that case since the 1940’s. There must be a distinction in the court’s mind between such cases and those that get characterized as being so old that they are “black letter law.” [Ruminations isn’t saying the case was “black letter law,” only that such a label gets applied by courts, with reverence, when convenient.]

In case any reader is wondering whether the landlord argued, and the court rejected, an argument that the result was “unreasonable,” they did.

If any reader is giving the court the benefit of the doubt, as a court is certainly entitled to receive, and thinks that the court wasn’t really giving the tenant a “windfall,” halt right there. According to the court, “[t]hat the Lease provides a windfall to [the tenant] as a result of the [landlord’s] breach does not rise to the level of unconscionability. Moreover, [the landlord’s] subsequent remedy of its breach should not deprive [the tenant] of its bargained-for right to abate rent and Charges.” That makes us wonder at what point the tenant first thought it could go rent-free until the allowance was paid, was it when it signed the lease or when it was sued for the money?

This isn’t the first, and won’t be the last, time when Ruminations or any of its readers become very puzzled about a court’s reasoning. That doesn’t make the court right or wrong. But, it does bring us to the key lesson taught by this case – if you don’t know that the word “abate” can mean “gone and lost forever,” it means that you don’t know what the word “abate” means. So, don’t use it. Yes, we’ve come full circle – “say what you mean, mean what you say.”

In any of these kinds of disputes over what a contract (such as a lease) means, there are losers and winners. [Actually, the legal profession seems to always be a winner.] Why should contracting parties let a court tell them what they meant by the words they used in a contract when they could have written what they meant?

Yes, this topic is an “evergreen.” We’ll be back to this forest again and again.

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Comments

  1. Barry Bell says:

    I am not surprised by this ruling. I see the lesson of this week’s column as advancing a corollary of “mean what you say.” I call it, “make sure you understand what can result from what you just said.”

    Ruminations states that it “wonders at what point the tenant first thought it could go rent-free until the allowance was paid . . . ” I submit it was long before the lease was signed. Although I personally think abatement is an egregious remedy here, I don’t think it is uncommon for grocery stores and other big box tenants to ask for, nay, insist upon, it.

    Nor do I think the landlord didn’t mean to agree that the rent would abate. t think if Sherman and Mr. Peabody could set the wayback machine for the year the lease was ready for signature and ask the landlord and its counsel what they thought would happen if payment of the allowance was late, both LL and lawyer would say, “the tenant doesn’t have to pay rent until it gets its allowance.”

    I think the LL failed to appreciate the potential that it would not be able to pay the allowance. I submit that the landlord’s team never contemplated “what if the tenant goes BK before the loan funds and we can’t get the money to pay the allowance.” If they had, I think LL’s counsel would have advised, “Tenant doesn’t have to start paying rent until it receives the money.”

    So perhaps LL did not intend that the rent would abate for 10 months, but I think it was the corollary at work here – the failure to understand what could result from what was said.

  2. I agree with Barry. Neither the LL nor his team ever fully considered the possibility that they wouldn’t be able to provide the Allowance within 90 days and therefore did not focus closely on this clause. And since A&P was probably going to be the anchor tenant for that strip mall in New Providence NJ, they would have acceded to any wording that A&P requested.

    However, I disagree with Ira on the customary meaning of “abate” in leases. Often when describing a “free rent period” leases speak of the first 2 or 3 months of rent being “abated”, with the intention that that rent will never have to be paid so long as the tenant performs for the term of the lease. So, even though I understand why this landlord chose not to pay the Allowance until the lease had been affirmed in bankruptcy, I’m not distressed or surprised that the tenant never had to pay rent for those 10 months.

  3. lewette fielding esq says:

    The economic reality is that the tenant probably could not complete construction of its premises absent the landlord’s payment of the construction allowance. The abatement
    language reflected the economic understanding of the parties — without the rent abatement, the premises could not be completed, the tenant would not have the use of the premises to generate income, and, therefore its rent should be waived during the period that the landlord occasioned the inability of the tenant to complete construction of the premises.

    To read the clause otherwise penalizes the tenant for the landlord’s default.

    Abatement, at least in NY practice, means that the landlord waives recoupment of the lease concession period. Occasionally, landlords will try to recoup the rent abatement in the event that the tenant defaults and the lease terminates.

  4. lewette fielding esq. says:

    Postscript The lease drafters did not contemplate the tenant possibly filing for bankruptcy — certainly, if language had been added, to suspend the landlord’s obligation to pay in the event of a bankruptcy filing, the outcome would have been favorable to landlord; however, as written, the court probably decided correctly. An argument might have been made that the tenant’s own conduct in filing for bankruptcy was an anticipatory breach excusing landlord’s performance; and, perhaps that argument would have been successful for the landlord.

    • “filing for bankruptcy was an anticipatory breach”
      uh…no.
      A tenant merely filing a bankruptcy petition isn’t – – as a matter of bankruptcy law – – a tenant default which would, for example, allow the landlord to terminate (even though the lease contains a clause that says it is). Such an “ipso facto clause” is void under the Bankruptcy Code. The same holds true for a landlord claim that its performance was excused because “the tenant’s BK petition was a breach”

      IMO the fault with Ira’s analysis is the assumption that when the landlord could not fund the payment to tenant DUE TO A FAILED FINANCING, the landlord is automatically free of fault, i.e., landlord is blameless . Unless the lease spelled out the specific circumstances out wherein the landlord is blameless, it is just as plausible that the landlord was expected to use project equity to fund the payment to the tenant.

      Yes the drafting was poor, but the judge was correct in the ruling, IMO.

  5. Alan Betus says:

    Am I missing something? When paying the Allowance, why didn’t the Landlord hold back the amount of rent that had already been abated? The Allowance was $1.9M, $1M of which had already been “paid” via the rent offset. Once Landlord received the loan, they should have only paid Tenant $900,000 (plus interest). This would make Tenant whole (or at least given them the benefit of their bargain). It would also have been reflective of (what I believe to be) Landlord’s intent – namely, that the “abatement” in this case meant “lessening” rather than “forfeiture”.

    Regardless of the theory used – liquidated damages or forfeiture, for example, I just can’t fathom that either party (beforehand) ever intended that Tenant getting to keep the $1M is the “correct” outcome.

  6. Henry Pharr III says:

    Good point Alan. I think that would have been a logical way to resolve this problem and in line with the the parties’ intent. Maybe the Court was sending Ira’s message to the parties’ when it reached this decision, but I still think it is a strained ruling that unfairly impacts the Landlord. Lesson learned though. The courts in NC have not construed “abatement” and “forfeiture” by these narrow definitions, but it is a warning to the lease drafter who does not take care in the language used and what it CAN mean if the black robes get a chance to review it long after the lease is signed.

  7. I agree with Ira in that we need to say what we mean and mean what we say, but then again that tends to make those leases we are drafting or reviewing go from 50 pages (in Nevada for example) to 174 pages in New York – saying what we mean takes a lot of words, oy vey! But, I agree with Lewette Fielding, had the lease indicated that the Landlord would only be obligated to pay the allowance, subject to the tenant being in compliance with all the terms and conditions of the Lease, with the filing of bankruptcy being defined as an event of default (subject to cure periods), the results I believe would have been vastly different.

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