Liquidated Damage Remedy Or Just A Bargained For Higher Rent?

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Though today’s posting isn’t really about “radius restrictions,” that’s what’s behind today’s observations about liquidated damage lease provisions. A radius restriction is a restrictive covenant. Thus, they have to be reasonable as to distance, duration, and scope. We’ve seen few modern cases centered on those parameters. So, we think restrictions that are coterminous with the lease term are reasonable as to time. Distances corresponding with a shopping center’s market area also seem reasonable. Limiting their scope to a lease’s use clause also seems to pass muster.

But, what is really a competing store? Suppose a tenant sells dresses under the tradename: “Alex’s Boutique” at a given property. Is it permissible for a dress shop a mile away, with similar price points and aimed at a similar class of customers, to operate under the tradename: “Shawn’s Boutique”? We hope you waited to read the following sentence. What if Shawn’s Boutique’s owner is totally unrelated to that of Alex’s Boutique? If your answer turns out to be that there is no reason why Shawn’s Boutique can’t operate a mile away, then why would it matter if Alex’s and Shawn’s had a common owner?

Many readers may see where we are going. If there is to be a radius restriction at all, logically it should be one that addresses whether the second location is “trading on” the success of the first one – “Is Shawn’s using Alex’s goodwill to draw Alex’s customers?” As we see it, even if the merchandise sold by each store is similar, the issue is one of “goodwill.” Shouldn’t Alex’s landlord know that any other retailer can open a competing store nearby and draw traffic? So, why not let an existing tenant operate under a different trade name and make that tenant financially stronger?

Another issue, even if the radius restriction is limited to stores under a common tradename doesn’t that assume that the landlord knows best what the marketplace will support? Perhaps the reality is that when a tenant opens a second, nearby store, it means that the tenant, based on information known to it and not to its landlord, has determined that the market will support both stores profitably. There will be customers available to the second location that weren’t going to shop at the leased premises. And, without the ability to grab a prime, nearby location, competitors may do so. That could threaten the tenant’s existing location, harming it and its landlord.

There’s a lot to be said on both sides of the radius restriction argument, and there’s even more to say about what should happen if a tenant violates one. But, that would be for another day. Today, we’re going to tell readers about how a Texas Court of Appeals eviscerated a landlord’s carefully crafted remedy when one of its tenants opened a second location using the same brand name as the one at the landlord’s shopping center.

Here’s the setup. A Shopping Center with an existing steakhouse leased to an additional restaurant. The new restaurant’s lease limited its sale of steaks to 20%. Let’s say its name was “Olde Tyme Grille.” Its parent company also had a chain of steakhouses under the name “Olde Tyme Steakhouse” and later opened one of those restaurants less than two miles from its Olde Tyme Grille. Absent any radius restriction in the Olde Tyme Grille’s lease, today’s blog posting would be covering a different topic. But, as reader’s suspect, the lease had such a restriction, in this case, a lengthy one, as follows:

Direction of Tenant’s Energies:

Tenant acknowledges that Tenant’s monetary contribution to Landlord (in the form of rentals), and Tenant’s general contribution to commerce within the Project (also important in Landlord’s determination to execute this Lease with Tenant) will be substantially reduced if during the term of this Lease, either Tenant or any person, firm, or corporation, directly or indirectly controlling, controlled by, or under common control with Tenant, directly or indirectly operates, manages, or has any interest in any commercial establishment as described below within five miles of the Project with (a) the same or similar Trade Name or (b) a concept that is the same as Tenant’s permitted use in the Demised Premises as described in Section 1.1(t) ((a) or (b) a “Competing Business”). Accordingly, Tenant agrees that if during the term of this Lease either Tenant or any person, firm, or corporation, directly or indirectly controlling, controlled by, or under common control with Tenant . . . either directly or indirectly commences the operation of or manages a Competing Business within a straight-line radius of five miles of the Project (the “Restricted Area”), which Tenant acknowledges is a reasonable area for the purposes of this provision, then in such event, the rent payable by Tenant hereunder will be adjusted as follows:

(a) for so long as the Competing Business is operating in the Restricted Area, the Minimum Guaranteed Rental will be one hundred ten percent (110%) of the amount stipulated in Section 1.1(n) of this Lease; and

(b) for so long as the Competing Business is operating in the Restricted Area, the Percentage Rental will be computed as if the “gross sales” from the Demised Premises were one hundred twenty-five percent (125%) (increased to one hundred seventy-five percent (175%) if the other store is within a two (2) mile radius) of the gross sales required to be reported to Landlord under the terms of Article 5 of this Lease for the same period.

The above adjustment in rental reflects the estimate of the parties as to the damages which Landlord would be likely to incur by reason of the diversion of business and customer traffic from the Demised Premises and Project to such other store within the Restricted Area, as a proximate result of the establishment of a Competing Business.

[We apologize for the length of this detailed lease provision, but we didn’t write it. And, perhaps its insistence on incorporating so much detail led to the landlord coming up “empty” before the lower court and again on appeal.]

On the facts, the tenant argued that its newly opened steakhouse was not a competitor to its existing “Grille.” One argument was that the Grille was limited in how much of its business could come from the sale of steaks. Restaurants of its character all sell steaks as part of a much broader menu than would be found on a “real” steakhouse’s menu.

The landlord, however, pointed out that the radius restriction was written in the disjunctive: it used “or.” According to the lease’s provision, the second location didn’t have to be a competitor; it was enough that it used the same tradename. In our description, that would be “Olde Tyme,” and the second location certainly shared that tradename.

Case closed. Not so fast! Did the landlord say “in the disjunctive”? Yes, and the court agreed. We’ll return to that thought.

The tenant couldn’t deny that “Olde Tyme” and “Olde Tyme” were identical tradenames. So, what could it argue when it obviously opened a nearby restaurant under the same (or similar) tradename? Why shouldn’t it pay the higher rental called for by the lease’s provision?

Well, according to the tenant, the landlord’s remedy was an unenforceable penalty and not one calling for legitimate liquidated damages. The court agreed.

Before we explain the court’s reasoning, we’d be remiss if we didn’t point out that the landlord argued the provision was actually an agreed-upon rent increase because the tenant wasn’t actually breaching the lease. It had the right to open as many similar-named businesses as it wanted so long as it paid a higher rent. This argument failed for two reasons. First, the landlord was careful to phrase the rent increase as damages when it wrote: “The above adjustment in rental reflects the estimate of the parties as to the damages which Landlord would be likely to incur by reason of the diversion of business and customer traffic…” Second, under Texas law, not unique to Texas:

there is no meaningful difference between a provision expressly prohibiting competition and a provision that imposes damages for engaging in competition. … Both are clearly intended to inhibit competitive conduct. … The fact that [the lease’s provision] does not characterize the establishment of a competing business as a breach does not change the function of the provision.

In our words, the court was not willing to elevate form over function.

But, that’s not what proved to be the landlord’s undoing, meaning that the tenant had no obligation to pay an increased rent even though it opened a nearby restaurant under the same tradename.

The court’s words are informative when it comes to what distinguishes an enforceable liquidated damages provision from one that a court will disregard:

Although parties are free to contract with respect to damages, this freedom is tempered by the “universal rule” that damages are limited to “just compensation for the loss or damage actually sustained.”

A damages provision that violates the rule of just compensation functions as a penalty and is unenforceable.

Provisions that apply the same measure of damages regardless of the magnitude of the breach are facially unreasonable and constitute an impermissible penalty as a matter of law.

Even in cases where the alleged breach is material, a “one size fits all” liquidated damages provision will not be enforced.

The lease was careful to address two separate situations – using the “disjunctive: or.” It defined a “competing business” as any business with either the same or a similar trade name OR a concept that is the same as the tenant’s permitted use of the leased premises. So, the lease would provide the landlord “with the same measure of damages regardless of whether the ‘competing business’ would divert customers from the leased premises.” Here is such an example. Suppose the restaurant’s parent opened a nearby retail store selling grills and barbeques under the name “Olde Tyme Grills and Barbeques”? Under the lease, the use of “Olde Tyme” would trigger an increase in rent. As such, the lease, as written, would “apply the same measure of damages regardless of the magnitude of the breach … and [this would] constitute an impermissible penalty as a matter of law.” Selling grills and barbeques is not competitive with operating a restaurant and even operating under the same tradename would not divert traffic away from the shopping center. Had the lease’s rent increase been triggered by a nearby restaurant using the same tradename AND competing with the tenant’s restaurant, the court would have upheld the lease’s provision. But because the disjunctive, or, was written, out went the rent increase. For that reason, though the lease was carefully crafted as a matter of drafting, it wasn’t carefully mindful of the law. Sometimes the law matters.

For readers interested in more information, the Texas court’s decision can be seen by clicking: HERE.

[As an aside, the landlord has asked the full appellate court to rehear the court’s decision.]

[As with this week’s posting, next week’s will appear early next Monday – another calendar conflict, the last for a while.]


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