Commercial Real Estate Leases: Planning Ahead for Early Termination

November1-17Long term leases of commercial real estate offer landlords a steady and reliable stream of income and provide tenants with an established business presence in a particular neighborhood. However, those benefits may be short lived in the event of an early termination of the lease.

Early terminations are typically caused by tenants who default under lease provisions but they may also be caused by landlords who choose to sell the property during the term of the lease. This article will address the ways landlords and tenants may protect themselves at the inception of the lease.

Commercial Landlords:  Rent Acceleration Clauses

Where an early termination results from a tenant’s default under the terms of the lease, the landlord is faced with the difficult task of re-letting the space to a new tenant.

A number of factors may influence the length of time that the commercial space remains vacant, including but not limited to, current market trends, the location of the space, and whether improvements were made to the space for the benefit of the long-term tenant that make the space more or less desirable to new tenants.  Thus, at the inception of the lease, it is important for landlords to take care to protect their interest in the event of a default by a tenant.

One of the best ways for landlords to protect their interests in the event of default by a long-term tenant is to include a liquidated damages clause in the lease.  Liquidated damages clauses specify a predetermined amount of money that must be paid in the event of a breach of the lease.  In the commercial lease context, a liquidated damages clause may provide for an acceleration of future rents owed following the early termination of the lease (“Rent Acceleration Clauses”).

Rent Acceleration Clauses provide landlords with security that they will obtain the full value of the lease in the event of an early termination from the defaulting tenant.  However, from the tenant’s perspective, Rent Acceleration Clauses constitute a significant penalty to pay for early termination of a lease.

November2-17Recently, Goldman & Pease represented a franchisor in a case where a franchisee tenant defaulted in a lease that contained a Rent Acceleration Clause, resulting in over $1 million owed to the landlord.  Even though the franchisor was not a party to the lease, the franchisor took significant steps to mitigate the landlord’s damages because the franchisor had an interest in maintaining its business presence at the leased premises. 

Those steps included, but were not limited to: 1) working with a brokerage firm in an attempt to locate a replacement franchisee to lease the retail location and 2) paying the rent due under the lease for over a year while the retail location remained vacant.

Notwithstanding the foregoing, the landlord sought to enforce the Rent Acceleration Clause against the franchisor.  The landlord knew that a collection action against the defaulting franchisee tenant would be futile because the defaulting tenant had no assets so the landlord filed suit against the franchisor.  The landlord argued that the franchisor was liable to pay all future rents due under the Rent Acceleration Clause because the franchisor had “assumed” the lease by making rental payments to the landlord in an attempt to mitigate the landlord’s damages.

While those parties ended up settling the matter, the current state of the law placed the landlord in a strong negotiating position for the following reasons.

A. Rent Acceleration Clauses are Enforceable

In Massachusetts, rent acceleration liquidated damages clauses are typically enforceable, provided two criteria are satisfied:

  1. at the time of contracting the actual damages flowing from a breach were difficult to ascertain; and
  1. the sum agreed on as liquidated damages represents a “reasonable forecast of damages expected to occur in the event of a breach.”

See Cummings Props., LLC v. National Communications Corp., 449 Mass. 490, 494 (2007) (holding liquidated damages clause enforceable where cited criteria fulfilled).

The Supreme Judicial Court (“SJC”) has upheld the enforceability of the rent acceleration clause, noting in pertinent part, that

“to the extent that the liquidated damages amount represented the agreed rental value of the property over the remaining life of the lease, decreasing in amount as the lease term came closer to expiration, it appears to be a reasonable anticipation of damages that might accrue from the nonpayment of rent.”  Id. at 496-497.

Thus, Rent Acceleration Clauses are enforceable where the sum agreed upon as liquidated damages represents a reasonable forecast of the damages to the landlord in the event of the tenant’s breach.

B. Landlords Have No Duty to Mitigate

Under Massachusetts law, commercial landlords have no duty to mitigate damages in the face of an enforceable rent acceleration clause.  See NPS, LLC v. Minihane, 451 Mass. 417, 421-423 (2008) (holding “in the case of an enforceable liquidated damages provision, mitigation is irrelevant and should not be considered in assessing damages.”)

C. Takeaways for Commercial Landlords and Tenants

November3-17Based on the current state of the law, a Rent Acceleration Clause will be enforceable provided that it represents a “reasonable forecast of damages expected to occur in the event of breach.”  This is because courts adhere to the concept of “freedom to contract” and provide great deference to the decision-making abilities of sophisticated parties to a contract.

In light of the enforceability test articulated by the SJC in the Cummings Props., LLC case, it may be prudent for commercial landlords to limit liquidated damages clauses to prevent an attack on the “reasonableness” of the rent acceleration provision by a defaulting tenant.  Some suggested limitations include:

  • Limit the amount of liquidated damages based on the duration remaining in the lease at the time of the early termination, as in the Cummings Props., LLC case;
  • Limit the amount of liquidated damages based on the estimated length of time necessary to re-let the premises; and
  • Incorporate the rationale for the clause into the clause itself so that there can be no dispute over whether the liquidated damages amount constitutes a “reasonable” measure of damages.

As for commercial tenants, it is imperative that they review liquidated damages clauses at the inception of the lease and seek to include a provision providing them with the option to off-set the landlord’s damages through mitigation.  Some suggested types of mitigation include:

  • Presenting new tenants to the landlord for review;
  • Working with brokers to identify a broader prospective tenant base; and
  • Limiting the amount of the liquidated damages payment based on a set duration after the space is re-let.

In Goldman & Pease’s recent case, the landlord was in a superior negotiating position than the franchisee due to the enforceability of the Rent Acceleration Clause.  However, the franchisee had no assets from which the landlord could recover all future rent owed.  In such cases, the landlord has an incentive to work with the tenant because otherwise the property could remain vacant for a substantial period of time, which reduces the property’s re-sale value, has a negative impact on adjacent businesses, and reduces the overall desirability of the lease space.

Commercial Tenants:  Notice of Lease

Sometimes, though not as often, it is the landlord rather than the tenant, that causes the early termination of a lease.  For example, a landlord may sell the building to a new owner who may seek to terminate the existing lease with the tenant to conduct massive renovations or to become an owner occupant.  If the lease term is for more than seven years, the subsequent owner is not obligated to recognize the terms of the existing lease unless the subsequent owner has prior “actual notice” of the lease.

To deal with this scenario, Massachusetts allows tenants with lease terms over seven years, to record or file a “Notice of Lease” at the Registry of Deeds in the county where the land lies.  See M.G.L. c. 183, § 4.  A Notice of Lease summarizes the key terms of the lease, including but not limited to, the commencement date, the duration of the lease, any extension and renewal rights, notarized signatures of the parties, a description of the premises matching the description in the lease, and a description of any additional area over which the tenant has an expansion option.

The purpose of a Notice of Lease is to provide notice to the world of the existence of the long-term lease.  Additionally, the law presumes that the subsequent owner has knowledge of all of the terms of the lease, even if they are not all contained in the Notice of Lease.  Thus, by recording a Notice of Lease, the long-term tenant is provided protection from a subsequent purchaser claiming ignorance of the long-term lease.

Conclusion

Like any legal contract, commercial real estate leases should be reviewed by an attorney prior to execution, particularly with a view toward protecting the landlord or tenant’s rights in the event of early termination of the lease.  While landlords have a strong negotiating position due to the enforceability of rent acceleration clauses, tenants may also protect themselves by seeking to include mitigation language in the lease and to record a notice of lease.

About the Authors

Attorney Howard S. Goldman is the founding partner of the law firm of Goldman & Pease LLC, 160 Gould Street, Needham, Massachusetts 02494 (781) 292-1080.  Mr. Goldman concentrates his practice in the areas of real estate, commercial leases, finance, and civil litigation, where he represents property managers, lending institutions, developers, and contractors for more than thirty-five years. He is an active member of the Massachusetts, Norfolk, and Rhode Island Bar Associations in his field and is also an active member of CAI and IREM, where he frequently lectures and writes columns affecting the real estate and finance industries.  Mr. Goldman serves as a member of the Zoning Board of Appeals for the Town of Needham and as a court appointed mediator at the Boston Municipal Court and as a pro bono advocate at Federal District Court mediations.

Attorney Kalee Polito, who practices real estate law and litigation at the firm, provided much assistance in preparing this article.