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An Unsettling Decision for Liquidated Damages in Settlement Agreements

In November, 2020, the Court of Appeals handed down a 4-3 decision with a new interpretation of the law of liquidated damages with regard to surrender agreements. Trustees of Columbia v. D’Agostino, —N.E.3d—, 2020 WL 6875988, 2020 N.Y. Slip Op. 06937 rewrites the rules of when a tenant simply gives up on the space.

In Trustees v. D’Agostino, two great icons of New York City had, as sophisticated business entities, negotiated the reduced rent of the space the famed supermarket chain was renting and eventually surrendered from the esteemed university. In their surrender agreement, the parties had negotiated for D’Agostino to make vastly reduced payments compared to those called for under the lease over a payout period, upon default of which payments, D’Agostino was to be held liable to Columbia for the full remaining amount of unpaid rent under the unexpired term of the lease the surrender agreement had canceled.

Background

Columbia, although having broad implications for the pandemic, did not arise from the pandemic itself, but four years earlier when D’Agostino stopped paying its rent under the lease from Colombia University. With some two years remaining on the lease and D’Agostino still in possession of the premises, the parties entered into a surrender agreement that called for D’Agostino to make payments calling for approximately $260,000, roughly a quarter of what the remaining payments under the lease would have been.

After the agreement was signed, the supermarket decided to surrenderer the premises and after making two of the $43,000 periodic payments called for under the agreement, D’Agostino stopped making further payments after Columbia re-rented the premises to a new tenant. As called for by the agreement, Columbia served a notice to cure and when D’Agostino failed to effect such a cure, Columbia invoked the agreement’s remedy of D’Agostino being called upon to pay the balance of the lease’s rent, some one million dollars.

Trial Term, the Appellate Division, and the Court of Appeals 4-3 found this to be an unenforceable penalty since the remaining payments on the surrender agreement would have been approximately $175,000. Thus, the majority courts focused on the ratio of the missed payments in the agreement to the consequence under the agreement, roughly 1:7.5 rather than the ratio of the lease payments waived to the lease payments reinstated, almost precisely 1:1.

The Majority Holding

In striking down the agreement’s reinstatement of the lease rent the agreement had waived, the court regarded the surrender agreement without regard to the amount of money owed and defaulted upon in the lease agreement. It refused to see the lease itself as part of the transaction—on grounds that the surrender agreement had cancelled it—looked only at the arithmetic of the piece of paper at hand and outlawed it. The court wrote, “(T)he Surrender Agreement constituted a new contract between the parties that terminated the lease and all prospective obligations flowing from the tenancy.” Viewing the surrender agreement as a new contract, the majority struck down the enforcement provision as an unenforceable penalty, rather than liquidated damages.

The majority’s holding reveals that not only does it reject disincentives to noncompliance in these surrender agreements, but it does so in all settlement agreements. Thus, does this holding reverberate through all fields of law that see actual or potential litigation.

The Dissent

A stirring dissent has the better side of the argument for both landlords and tenants and all businesses trying to survive an economic depression. The dissent argues that the surrender agreement and the lease should be read together as one single transaction, that the majority’s rule discourages settlements and in so doing actually acts against distressed tenants, and that sophisticated business entities should be allowed to craft their own deals. It wrote, “This result is incompatible with our freedom of contract precedent and the strong public policy favoring enforcement of settlement agreements.”

The dissent highlights that now given a choice between a defaulting tenant who has impunity for defaulting, and a defaulting contractor who has no reason to obey the surrender agreement, the landlord has no incentive to enter a surrender agreement at all. The dissent writes, “This will discourage commercial landlords from agreeing to settlements of this nature, to the detriment of defaulting tenants…” The majority dismisses this argument, holding that the landlord got what it bargained for, an opportunity to re-rent the space. But the landlord is not actually in the business of trying to rent space. The landlord is in the business of having rent paying tenants and it is of this bargain the majority’s decision did deprive the landlord.

‘Columbia’ Harms Business

Perhaps the Columbia’s majority ruling is limited to cases where, as here, the tenant is, as part of the entire deal, surrendering the premises, and the only remaining question between the parties is not how to govern a struggling tenancy, but how to fund a failed one.

The problem, however, is that the majority decision, if applied to ongoing tenancies, severely restricts the viability of the forbearance agreements that continue to be so essential during this depression, if not for supermarkets who continue to do a brisk trade under current conditions, then certainly for restaurants, gyms, and other gathering places that are struggling with severely reduced patronage.

The majority fails to appreciate the needs of the commercial landlord and tenant. Street litigators who practice every day need these tools to make deals to keep tenants in business while having a means to collect the rent and evict if the business that has been given the second chance, cannot pay.

Were it not so easy to get around the majority’s ruling, its effect could be truly seismic in these times when so many tenancies are failing through fault neither of their own nor of their landlord. These are horrific times for business. Tenants, and especially their guarantors, need a safe way out of their no longer viable tenancies and landlords need to be able to offer such safe passage. The dissent correctly argues that the majority makes it difficult for landlords to offer such.

What Commercial Landlord-Tenant Relationships Need

Landlords, in these times, need to reduce risk. So do tenants. The Columbia majority dismisses this, writing:

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.

Yet, in Holy Props. v. Cole Prods., 87 N.Y.2d 130, 637 N.Y.S.2d 964 [1995]the Court of Appeals was far more solicitous of risk avoidance when it wrote, “Parties who engage in transactions based on prevailing law must be able to rely on the stability of such precedents.” Preservation of stability was the issue in Holy Properties, but in Columbia, it is something too easily dismissed.

Of this, the dissent notes, “This principle of New York contract law has special import in real property transactions where, as here, commercial certainty is a paramount concern.” (Punctuation and citations omitted.)

Drafting Agreements in the Real World

Those of us who do this kind of practice, know that in crafting an agreement, any kind of agreement, whether it is an agreement that is essentially transactional in nature or one that is after the relationship between the parties has broken down, we face two categories of questions: (1) What obligations do we seek to impose on each other? (2) And how shall we make sure the other side honors those obligations?

In answering the second question, we tend to think in two categories, carrots and sticks. We hunt for carrots that can encourage compliance and we look for sticks that punish noncompliance. As to the carrots, there is always the problem when one side has already, in the agreement, given up everything it has to offer. This is typical of surrender agreements. The landlord has already agreed to forego its income flow and to accept either immediate surrender of possession or the tenant remaining in possession accompanied by a vastly reduced payment, typically over an elongated payment schedule. There are even agreements tenants and landlords are negotiating calling for immediate surrender, but already setting forth the terms of re-occupancy should the landlord fail to find a replacement tenant and the tenant wants to return after the pandemic. With all of these concessions from landlords, there are no incentives left to sweeten the pot so as to ensure compliance.

As to sticks, the doctrine of unenforceable penalties makes it difficult to craft remedies that contain just enough terror attached to the noncompliance as to discourage it, but not so much as to be struck down. Here, Columbia’s attorneys had a relatively mild “stick.” Under the terms of the agreement, if it defaulted in the agreed reduced payments, D’Agostino was then to pay what it had originally contracted to pay anyhow under the lease, but for the agreement.

Of course, there is always the possibility of nonmonetary carrots and sticks, but thus far, the doctrines of unenforceable penalties do not reach into these nonmonetary matters. For example, in ordinary agreements dealing with a tenant’s nonpayment of rent, failure to adhere to the schedule set forth in the agreement can lead to eviction. However, in surrender agreements, it is generally too late in the tenancy to employ such an agreement, but in other kinds of agreements, nonmonetary consequences for failure to live up to contractual obligations could occur. With increasing hostility to severe consequences for noncompliance coming from the Court of Appeals, as evidenced at first by 172 Van Duzer Realty Corp. v. Globe Alumni Student Assistance Assn., Inc., 24 N.Y.3d 528, 536, 2 N.Y.S.3d 39 [2014] and now by Columbia, nonmonetary inducements to compliance might also fail as “unenforceable penalties.” This line of decisions, based on well established principles of the law of liquidated damages and unenforceable penalties, is becoming so strict as to hamstring negotiators trying to put together a viable deal. If the law degenerates to “the weaker party always wins,” stronger parties have no further motivation to negotiate at all.

Recall that under Holy Props. v. Cole Prods., 87 N.Y.2d 130, 637 N.Y.S.2d 964 [1995]a commercial landlord has no duty to mitigate its damages when a tenant abandons a lease. 172 Van Duzer Realty Corp., supra, softened the hit tenants would take under such circumstances by insisting on a discount for present value, but it did not altogether outlaw the acceleration of all future rent coming due immediately. But under Columbia, which cites to both Holy Properties and 172 Van Duzer Realty Corp., under the guise of liquidated damages doctrine, the full accelerated rent is an illegal penalty if it is the contracted for alternative to making a negotiated vastly reduced payment.

We note that Columbia does not leave the jilted landlord completely without remedy. If the jilting tenant fails to make a payment under the surrender agreement, the jilted landlord may enter judgment for the payments that were supposed to have been made in the surrender agreement as if the tenant had been in compliance. In short, lacking any carrots to offer the tenant for compliance, Columbia removes all sticks for noncompliance and the only thing that the jilted landlord gets is a judgment for the payments that were agreed to and should have been made. There is, for the tenant, neither incentive to comply, nor disincentive to default. Indeed, in Columbia landlord is awarded a judgment without any indication as to whether D’Agostino actually paid off the judgment. Of course, we recognize that failure to get paid on a smaller judgment is no greater monetary loss than failure to get paid on a higher one.

How Parties Can Still Negotiate

However, for the careful drafter, not all is lost. One can draw up these agreements so as to elude the harsh and impractical rules of Columbia.

At the core of Columbia’s holding is that since the surrender agreement terminates the lease, the agreement cannot go on to use the lease as a metric for the money that would have been owed. The simple solution to this is not to terminate the lease. These agreements can be called “Amendments to Lease Agreement” so as to distinguish them from the surrender agreement Columbia strikes down.

In a properly drawn post-Columbia quasi-surrender agreement, instead of the agreement terminating the lease, it modifies it. Thus, the agreement should take the form of a lease amendment, restating and affirming the obligations of the lease, but modifying them so that so long as the tenant timely makes the payments called for in the lease amendment agreement, the landlord shall accept them in lieu of full rent. As long as the tenant makes the payments, the tenant stays in possession.

For those agreements where the surrender of the premises is being negotiated, amend the lease so the amendment to the lease would accelerate all the rent due on the balance of the lease with the implementation of a Van Duzer discount for present value, together with a termination of all further possessory rights the tenant may have. The actual surrender of the lease would need to be delayed until a new tenant is found.

Conclusion

Columbia v. D’Agostino is an unfortunate precedent. It does, as the dissent points out, discourage the drafting of surrender agreements in their traditional form. However, there is an out. Landlords who seek to come to terms with their tenants who cannot make a go of it need not fear the harsh rule of Columbia. Instead of a freestanding agreement, the parties may simply modify the lease so as to make it work for them correctly. These are horrible economic times, but we lawyers possess the tools necessary to ease nonfunctional relationships and to make them workable.

 

Adam Leitman Bailey is the founding partner and Dov Treiman is the landlord-tenant managing partner of the Manhattan law firm, Adam Leitman Bailey, P.C.

 

Original article here

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