Enforceability of Lease Buy-Out Provisions No Longer an Option for Tenant Breaches
By Christopher R. Walker
For many years now, many single and multi-family operators and owners have insisted on lease buy-out language being placed in their lease agreements. These provisions were meant to be in place for tenants to voluntarily buy-out of their lease. Under these provisions, tenants are typically required to provide anywhere from thirty to sixty days’ notice of their intent to terminate and pay the landlord a buy-out fee equal to one or two months’ rent plus the repayment of any previously awarded rental concessions. While this was employed as a mechanism for tenants to break their lease agreement, the lease break provisions are often being invoked as liquidated damages and assessed against tenant accounts when tenants skip or otherwise break their lease agreement. Until recently, there was no authoritative opinion either condoning or rejecting this practice. The Arizona Supreme Court has recently decided an issue that greatly impacts the ability to charge these lease buy-out fees and questions their characterization as liquidated damages. In Dobson Bay Club II DD, LLC v. La Sonrisa de Siena, LLC, 242 Ariz. 108 (2017), the court sought to examine a late fee assessed pursuant to a promissory note. Essentially, Dobson Bay Club breached the promissory notice and failed to make the balloon payment on time. La Sonrisa purchased the promissory note from the original lender and noticed a trustee’s sale on the collateral. La Sonrisa contended that, in addition to the remaining principal balance and interest, Dobson Bay owed La Sonrisa a late fee equal to $1.4 million. Dobson Bay paid the outstanding balance owed on the note including the interest, deposited the $1.4 million in late fees with the court, and commenced litigation over the demand for the $1.4 million in late fees. The court, in rendering its decision went through the history of liquidated damages provisions and the court’s rules in examining the reasonableness and appropriateness of said provisions. Ability to Contract for Damages
It is undisputed that parties to a contract can agree to various terms regarding damages to be owed to the other in the event of a breach of the contract. Parties are free to agree, in advance, as to what those damages would be based on the type of breach identified in the damage provision. These types of provisions are called liquidated damages provisions. A liquidated damage provision serves to provide certainty when actual damages would be difficult to calculate and they alleviate the need for potentially expensive litigation. As a general rule, contractual remedies are not meant to be punitive. Contractual remedies are meant to be compensatory. Any provision that is considered by the court to be punitive in nature will likely not be given effect in any legal proceeding. Likewise, a contractual term that fixes an unreasonably large liquidated damage is unenforceable as a matter of public policy because of its perceived punitive nature. Generally, a non-breaching party is not required to prove actual damages in order to enforce a liquidated damages provision. However, the court will only respect the parties’ decision on the liquidated damages provision so long as the damages awarded under the provision are reasonable in relation to anticipated or actual loss. Additionally, if the damages stemming from the breach are not difficult to calculate or the damages awarded under the provision are grossly disproportionate to the damages actually suffered then the court would likely find the provision unreasonable and decline to award the damages.
Enforcement Test for Liquidated Damages Provisions
As you can imagine, the court employs a test to determine if the liquidated damages provision is enforceable. The test is derived from the Restatement Second of Contracts § 356(1) which provides that the court must consider (1) the anticipated or actual loss caused by the breach and (2) the difficulty of proof of loss. The second element is the most critical in this test. In Dobson Bay, the court found that the late fees were not justifiable. La Sonrisa made claims that the late fees were meant to defray costs associated with the breach. The court was not persuaded by this argument. The court pointed out that the late fee had no relation to the duration of the breach. The $1.4 million late fee could be applied if the balloon payment was one day late or even one year late. The duration of the breach was not distinguished in the damage provision at issue. It took absolutely no consideration of how long the breaching party was in default, something that the court found was proof that the damage provision as disproportionate to the damage actually sustained. Additionally, the court took aim at the liquidated damage provision and the difficulty in proving the loss stemming from the breach. The court concluded that the damages that it would have suffered and the loss incurred would have been easily quantifiable. La Sonrisa could have easily produced a record of the time it spent in processing the file and handling the trustee’s sale. In essence, the court found that the $1.4 million fee was simply a windfall to La Sonrisa with no regard for the actual damages sustained. The court noted that La Sonrisa was not precluded from filing a lawsuit to recover its actual damages, it only decreed that the enforcement of the $1.4 million in liquidated damages was not permissible under state law.
Effect of This Ruling on Multi-Family Contracts
Owners and operators of single family and multi-family rental properties have already started to see an impact from this decision. Several judges in Southern Arizona have been reluctant to use the lease buy-out provision as the calculus of the damages associated with a tenant’s breach of the lease. These judges have asserted that the proper measure of damages is the lost rent suffered from the tenant’s breach plus any additional costs associated with the breach itself. These judges’ decisions appear to be in alignment with the holding from Dobson Bay. Rental contracts are fixed term agreements. When a tenant breaches the owner is deprived of rent from the date of the breach through the date the property is re-rented. The time in between the breach and the re-rental of the property is easily calculated. Likewise, any other damages stemming from the breach including turn fees, marketing costs, and changes in rental market value are relatively easily discernable. Using the logic of Dobson Bay, these types of damages could not be covered by the lease buy-out clause and, therefore, the lease buy-out charge would not be the proper basis for the damage assessment. As more and more judges consider the holding of Dobson Bay, more and more cases involving claims for payment of the lease buy-out fee as liquidated damages will be called into question. With the above in mind, owners and operators of multi-family or single family rental properties need to be mindful of the actual damages sustained as a result of the breach. They should develop a fee sheet to detail out all expenses and costs incurred as a result of a breach of the lease to include turn fees, marketing costs, and changes in rental value that may have the effect of reducing the value of the contract that the new tenant executed. These are the kind of damages that the court will consider and likely award if proven. However, reliance on the lease buy-out fee as demonstration of the damage suffered from a breach is likely to yield and unfavorable result.
Christopher R. Walker is an attorney with the Law Offices of Scott M. Clark, P.C.. He can be reached at 602.957.7877.