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California Court of Appeal upholds holdover rent in AIR Lease form

In Los Angeles commercial and industrial real estate, owners, tenants and attorneys often use the AIR Commercial Real Estate Association pre-printed form leases.  These form leases are thorough, fairly written and easy to use. Moreover, the parties to the lease and their lawyers are usually familiar with the various terms of the form lease, making it easier to negotiate the salient points.  Lastly, the AIR Association has industry experts who constantly make changes to the forms so that they are in line with current California law.

The AIR leases include a holdover rent provision which governs when a tenant overstays the term without permission.  In the case described in this article, the holdover provision of the lease read as follows:

“26.  No Right To Holdover.  Lessee has no right to retain possession of the Premises or any part thereof beyond the expiration or termination of this Lease.  In the event that Lessee holds over, then the Base Rent shall be increased to 150% of the Base Rent applicable immediately preceding the expiration or termination.  Holdover Base Rents shall be calculated on a monthly basis. Nothing contained herein shall be construed as consent by Lessor to any holding over by Lessee.”

A new case by the California Court of Appeal examined whether this holdover provision constituted an “unenforceable penalty” or an allowable “graduated rental”.  Below is an analysis of the court’s finding (the holdover rent provision is an allowable graduated rental) and the dissent’s persuasive case that it is an unenforceable penalty in keeping with existing California law.

1. Factual Background:  World Trading Did Not Vacate The Premises On Time

A commercial warehouse landlord in Los Angeles, Constellation-F, LLC, leased warehouse space to tenant World Trading 23, Inc.  The lease was a AIR pre-printed form lease and included the No Right To Holdover provision above. The term of the lease expired on February 28, 2016.  The parties to the Lease agreed by written amendment to extend the expiration date to April 1, 2016 and to suspend the holdover rent during this time.

World Trading missed the deadline and did not vacate the property until June 15, 2016.  Constellation filed an unlawful detainer action and later sought damages, including past-due rent, late fees, interest, failure to maintain and repair, costs incurred by not being able to use the property, and holdover rent.

The trial judge in the Los Angeles Superior Court found World Trading liable for all damages…except for the holdover rent.  The court ruled that the holdover rent was an unenforceable penalty. Both parties filed appeals but, interestingly, World Trading did not respond to Constellation’s brief.

2. What Is A “Graduated Rental”?

The Court of Appeal cited to a 1942 case for the proposition that holdover rent is a “graduated rental” and noted that “[c]ommercial provisions of this sort are enforceable even if the increased rent is much greater than the base rent” and cited to the 1942 case as upholding a 500 percent increase.

The court defined the graduated rental as the rate for leasing the property and therefore the prohibition on penalties does not apply.

3. Are Commercial Real Estate Players Free To Contract In Their Own Best Interest?

Much of the court’s analysis rests on the idea that “market actors are freely able to contract in their own best interest” and “[t]hey dealt at arm’s length.  Deliberately and free from coercion, they made the provision for the rental to be paid for the use of the premises after the expiration of the definite term. This they had the right to do.”

The court then concludes that “the trial court should have enforced the holdover agreement, ‘which the parties [had] determined by their free, solemn and voluntary act.’”

4. Does Civil Code Section 1671 Apply?

California’s Civil Code section 1671 addresses liquidated damages.  Real estate professionals are familiar with liquidated damages provisions as set forth in purchase and sale agreements but this is an arcane issue that may only be of interest to experienced real estate attorneys.  In general California law prohibits damages that are unreasonable under the circumstances existing at the time the contract was made. In cases where it would be impractical or extremely difficult to fix the actual damages that would arise from the breach of a particular contract, the parties may do an evaluation and agree on a ‘liquidated damages’ amount when entering the contract.  For example, the AIR Standard Offer, Agreement and Escrow Instructions for Purchase of Real Estate includes a liquidated damages provision at paragraph 21.  This liquidated amount in real estate transactions often equals the earnest money deposit amount.

World Trading argued that Civil Code section 1671 applied and that this punitive rental rate was an unreasonable liquidated damage for breach of the contract.  The Appellate Court quickly disposed of this argument, stating that the 1942 case had “rejected this erroneous argument: ‘Neither the question of penalty nor of liquidated damages is involved in this action.’”  At another point in the opinion, the court stated rather elliptically that “[g]raduated rentals are not damages. A graduated rental is the rate for leasing property. By its terms, then, Civil Code section 1671 did not apply to a holdover rent provision….”  Both of these conclusory statements fail to address the issue.

5. Was There Coercion?

The Court of Appeal opinion makes much of the fact that there was no coercion in this case.  It then states that “[w]hen the concern about oppressive coercion is absent, Civil Code section 1671 does not apply.”  Moreover, the court states that “[c]oncerns about coercion are absent when one side has ‘a considerable range of choice as to the type of arrangement [it] wishes to enter’ with the other side.”

The Court noted that even after the lease amendment, World Trading was “at complete liberty to avoid the higher rent.  It had merely to leave.”

6. Does The Dissent Make The Better Argument?

The dissent is longer than the original opinion.  In general the dissent notes that this opinion sets forth a new test by which one may challenge a liquidated damages provision, ignoring the existing statute and common law decisions.

Typically a liquidated damages provision is analyzed by whether the parties attempted to analyze estimated anticipated losses arising from breach of the contract.  The majority’s opinion, however, seems to center on whether there was coercion and did one party have outsized respective market power.

The dissent observes that Civil Code section 1671 applies to leases (section 1951.5) and that a provision in a contract liquidating the damages for breach of the contract is valid unless the party seeking to invalidate it establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.  In other words the proposed penalty must bear a reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach. Moreover, the parties must engage in a “reasonable endeavor” to estimate a fair average compensation for any loss that may be sustained. Otherwise it is a penalty.

“The characteristic feature of a penalty is the lack of a proportional relation to the damages which may actually flow from the failure to perform under a contract.”

Therefore the general rule, according to the dissent, for whether a contractual condition is an unenforceable penalty “requires the comparison of (1) the value of the money or property forfeited or transferred to the party protected by the condition to (2) the range of harm or damages anticipated to be caused that party by the failure of the condition.  If the forfeiture or transfer bears no reasonable relationship to the range of anticipated harm, the condition will be deemed an unenforceable penalty.”

The dissent notes that in this case neither Constellation nor World Trading made any effort whatsoever to determine an estimate of anticipated losses if World Trading overstayed its lease.  Nor was there evidence of extreme difficulty or impracticability in setting damages. In fact the parties never discussed the provision in any way at the time of entering into the lease.

With regard to “freedom of contract” the dissent pointed out that business owners are entitled to the protections against unreasonable penalties as set forth in section 1671.

The dissent also evaluated the testimony of several real estate professionals who were instrumental in drafting the AIR Lease form.  The dissent points out that while the AIR form was reasonable for the industry as a whole, section 1671 requires a new and individual evaluation of every particular contract.

7. Who Has The Better Argument?

As a commercial real estate litigation attorney, I am glad to see that the Court has allowed the holdover rent provision of the AIR lease.  It provides a disincentive to tenants who fail to vacate in a timely manner. However, it is hard to square the Court’s logic with existing law regarding unenforceable penalties.

My clients are typically sophisticated commercial real estate owners and investors who have experienced and smart real estate transactional attorneys.  I believe that these sophisticated parties should be free to contract. But California law is full of nanny-state laws that prevent commercial parties from freely contracting.  Think of the prohibition on waiving jury trials and electing a court trial instead. Even stipulated judgments in court must be structured to avoid including unenforceable penalties.

Whether I as a property lawyer agree with the ban on unreasonable penalties or not, the law is the law, at least until this opinion came out and muddied the waters.  This new test of whether there is ‘coercion’ or not may be a good test but it is not the test enunciated in existing law.  

However, the old test of trying to determine estimated damages suffers from the same problem as the new test—a landlord and tenant will have to engage in expensive and time-consuming litigation with no reasonably objective standard to guide their analysis.  What is ‘reasonable’ is left to each judge as he or she sees fit and that can only be determined after a trial.

As the dissent points out, liquidated damages require that the parties endeavor to ascertain the estimated actual damages in each particular contract.  This seems unreasonable. The AIR Lease attempts to set an industry standard based on a percentage of rent. Lower rent tenants will have lower holdover rents.  Higher rent tenants will have higher holdover rents. The law should allow an industry standard rather than requiring that every time parties enter into a lease they must go through this exercise of estimating anticipated damages in the event of breach.

And how does this decision affect other parts of the typical commercial lease or purchase and sale agreement?  Will the ‘no coercion/freedom to contract’ test be used in those cases where a party attempts to designate an earnest money deposit as non-refundable at the outset of the agreement?

Laine T. Wagenseller is a commercial real estate litigation attorney with Wagenseller Law Firm in Los Angeles.  The firm specializes in helping the commercial real estate industry resolve their disputes and protect their property.

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