Liquidated Damages: How Much Is Too Much?

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Imagine a landlord delivers promised space 84 days beyond the target delivery date, and the tenant gets 755 days of rent credit. That’s a little over two years’ of free rent for a delay of a little less than three months. Is that appropriate? Is it lawful? Is it a proper measure of damages? Is it a penalty imposed on the landlord? At the end of March, a federal judge in Pennsylvania, applying New Mexico law, answered the legal questions. She ruled that the 755-day rent credit was an acceptable approximation of damages and was not an unenforceable penalty. Ruminations has no argument with the court because, when it comes to whether an agreed-upon damages provision in a lease is enforceable, the unvarying answer is: “It depends.”

A good place to start is with the lease’s late delivery provision:

Tenant shall receive five (5) days of abatement of Minimum Rent and Other Charges due under the Lease (the “Late Delivery Credit”) for each day that the Actual Delivery Date is delayed past the Target Delivery Date. If the Actual Delivery Date is not delivered to Tenant within fifteen (15) days after the Target Delivery Date, then beginning with the sixteenth (16th) day after the Target Delivery Date and continuing from each day of delay thereafter, the Late Delivery Credit shall increase to ten (10) days of abatement of Minimum Rent and Other Charges for each day of delay. Landlord acknowledges that Tenant shall incur substantial damages in an amount which will be difficult to ascertain if Landlord fails to deliver possession of the Leased Premises to Tenant in the condition required hereunder on or before the Target Delivery Date, and that the Late Delivery Credit represents a reasonable estimate of such damages and will not constitute a penalty.

We’re talking about something called: “liquidated damages.” This is an amount agreed upon by contracting parties within their contract, well before any breach occurs if one occurs at all. At that point, the parties don’t know exactly how much the breach will “cost,” but they want some certainty. They don’t want to argue about the loss experienced by the non-breaching party. They don’t want the amount to be open-ended in either direction.

So what do they do? Under the law, a breaching party is expected to make the other party “whole.” A key principle of contract law (and a lease is a contract) is that each party is entitled to the benefit of its bargain. There is no place for “penalties.” A breaching party isn’t supposed to be punished. If its breach causes a monetary loss, it is expected to cover that loss, but not more. Yes, that’s often easier said than done.

So, we have a small conflict. If “contact” law limits what a party has to pay to the other party’s monetary loss, we’d always have to wait until after the breach to see “what happened.” So, we give parties great latitude to reach agreements between themselves (“freedom of contract”). If they want to have certainty over how much one would pay and (consequently) the other would receive, we let them include that amount in their agreement. But, there are some rules, or more appropriately, guidelines, for what the law will allow them to do. That way, the agreed-upon amount will more closely resemble “damages,” and less likely resemble a “penalty.”

The rule has been stated in a lot of different ways, but here is its essence. To be enforceable, the amount of pre-agreed damages or a formula for calculating those damages will be enforceable, and not treated as an unenforceable penalty, if: (a) it is certain that the receiving party will be damaged; (b) the amount of damages, if and when incurred, would not be determinable with certainty; and (c) at the time of contracting, the parties have made a reasonable estimate of what those damages would be. The “reasonably estimated” damages are called: “liquidated damages.” Almost all post-breach disputes over the enforceability of liquidated damages involve a large discrepancy between what the actual damages turn out to be versus what the “estimate” was in the contract. Interestingly (to Ruminations), it seems that it is almost always the “payer” who complains to a court that the agreed-upon liquidated damages should be struck as being “too high.” We don’t recall ever seeing a challenge to such damages by the recipient as being “too low,” though there have to be such cases.

So, in this United States District Court decision (partially overturning a Bankruptcy Court decision), the issue was whether the 755-day rent credit that resulted from the lease’s liquidated damages provision demonstrated that the provision’s “estimate” of likely damages was unreasonable.

New Mexico law agrees that to be enforceable damages, the stipulated amount has to have been a reasonable estimate. In the words of its Supreme Court:

Since there was no evidence that the amount of the liquidated damages was an unreasonable estimate at the time the subcontract was made, we think the trial court erred in not applying the liquidated damages clause.

But, New Mexico has a more precise “test” for enforceability of a contract’s liquidated damages provision:

With regard to liquidated damages clauses, the New Mexico Supreme Court has stated that, generally, the “enforcement of such a clause will only be denied when the stipulated amount is so extravagant or disproportionate as to show fraud, mistake or oppression.”

Another issue in these disputes concerns which party has the burden. Is it the breaching party, here the landlord, who needs to show that the initial estimate was unreasonable or is it the damaged party who needs to show that the estimated amount was reasonable? In New Mexico, the party asserting that the agreed-upon liquidated damages should be “tossed” as an unenforceable penalty has the burden of proof. It needs to show that the agreed-upon amount was “so extravagant or disproportionate as to show fraud, mistake or oppression.,” Other state’s laws might define the test differently and they might shift the burden to the injured party. So, go with today’s flow. Don’t assume that “your” state will look for fraud or oppression or would have put the yoke on the landlord’s shoulders..

Though the damaged party would, in the first instance, have the information or data that would better show its actual damages, the breaching party should have access to that information through the legal discovery process.

Now, here’s a slight digression, but a relevant one. It shouldn’t matter how much the eventual damages turn out to be. The test is supposed to be whether the estimate was reasonable “at the time of the agreement.” At that time, there would have been no information at all as to what the “actual” damages turned out to be. So, “how it turned out” shouldn’t be part of a court’s analysis. In practice, however, many courts take the outcome into consideration. Here, however, the federal court did not. It solely asked the landlord to prove that 755 days of free rent was “so extravagant or disproportionate as to show fraud, mistake or oppression.”

The landlord and tenant were both experienced businesses, and the court found no evidence of fraud or oppression. The landlord’s argument was that “the liquidated damages clause was extravagant and/or disproportionate ‘on its face’ because the application of the clause translates into over twenty-five months’ worth of rent abatement for a delivery that was three months late.” The court, rightly in our view, rejected this argument. In doing so, it wrote:

While the calculation of damages may equal twenty-five months’ worth of rent credit, that comparison is irrelevant because the calculation at issue is tied to the loss which might reasonably have been anticipated at the time the Lease was signed. … In other words, it is an estimation of anticipated damages incurred by [the tenant] for failure of [the landlord] to deliver the property on time, not how much that figure eventually equals in terms of rent, as [the landlord] suggests.

The lower court tried to walk a line when it made its ruling. It accepted the three-day rent credit for each of the first 15 days of late delivery but rejected (as a penalty) the ramp-up to ten days for each subsequent day of late delivery. The District Court rejected that analysis. Basically, it held that you can’t rewrite these provisions for the parties – it is all or nothing.

Readers, these disputes are fact-dependent. Further, even though liquidated damage principles would seem to bar a “look-back” based on what actually turned out, courts do that all the time. So, there isn’t a lot to be learned by reading one court decision. A better sense can be gotten by reading dozens. If you do so, we think you will come to the same conclusions we have reached. First, courts use their “gut” feeling, often by looking back with hindsight, thus eviscerating the concept of liquidated damages – giving one party or the other a second chance to negotiate what had been agreed-upon. Second, courts (and many parties) don’t understand that these rent credits have no real connection to rent. They are just measured by the amount of rent. They could just as easily be stated at a given dollar amount per day. Let us explain.

The loss a tenant experiences with late delivery is not what it will be paying as rent. It is the profit it expected to earn or the overhead cost it expected to cover from store revenues beginning with the agreed-upon delivery date. The loss of expected profit is pretty easy to understand. It is clearly a part of the tenant’s expected “benefit of the bargain.” But, the amount of “lost” profit is not limited to the actual days missed. For example, a fashion retailer often works within “seasons.” If delivery of the space was timed to the spring or fall (or back to school) seasons, anything more than a slight late delivery can cost an entire season. In preparation for a store opening date, merchandise is ordered well in advance. A significant late delivery means a closeout sale. And, a closeout sale cannibalizes sales in the following season. There are also unrecoverable costs that are incurred in anticipation of opening on time. Staff will be hired. A tenant may be able to delay wage payments for many employees, but that’s not likely for the store manager, someone who will be working as an “extra” at another location. Contractors will be placed on hold. Store fixtures will be in storage, at a cost to the tenant. Advertising contracts might be canceled at a penalty. There are dozens of other costs incurred that store revenue would have covered.

So, what’s the bottom line here? Ruminations has no idea if it was reasonable to estimate ten days of loss to the tenant for each day delivery was delayed, but it doesn’t seem outlandish. To us, New Mexico law seems to be a pretty good approach when applied in situations where overreaching by a party is absent. When negotiating a lease, the parties are in the best position to assess their respective risks and to negotiate a liquidated damages provision to “cap” that risk. Certainly, there are situations where a supposed liquidated damages provision plainly doesn’t pass the “smell” test, but in our experience and reading over many years, those situations almost always also show evidence of grossly unbalanced bargaining power and more.

[Readers desirous of seeing the District Court decision can do so by clicking: HERE.]

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Comments

  1. Jeremy Deeken says:

    In addition, if the actual damages were equal to the rent payment due, then they would be easy to estimate – the element of uncertainty would be missing to justify the liquidated damages provision.

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