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The Enforcement of Liquidated Damages Provisions for Breach of Continuous Operation Clauses
Sedgwick's Real Estate Newsletter
Continuous operation clauses are common in shopping center leases but, for years, there has been concern about how to enforce such provisions. The California Court of Appeal recently addressed that question in El Centro Mall, LLC v. Payless ShoeSource, Inc., 174 Cal.App.4th 58 (2009), holding that the landlord was entitled to liquidated damages when they were provided for within a covenant for continuous operation.
Because shopping centers typically rely upon a mix of stores to draw foot traffic, commercial shopping center leases often contain express covenants requiring the tenant to remain in operation throughout the term of the lease. Indeed, the law implies such a clause if the rental charge is based in part on a percentage of the proceeds from the tenant's business, and the base rental is otherwise inadequate. See, e.g., Lippman v. Sears, Roebuck & Co., 44 Cal.2d 136, 143 (1955). Determining whether the base rent is "adequate" can be a tricky process, so if a landlord intends to enforce a covenant for continuous operation, it should expressly state so in the lease. See, 7 Miller & Starr, California Real Estate, § 19:53, p. 47 (3d Edition 2001).
Civil Code section 1951.4 codifies a landlord's ability to include a continuous use provision in a commercial lease. So long as the provision is expressly stated, and allows the tenant to mitigate by sublease or assignment, the provision is valid. Ibid. Under such a provision, the landlord can recover the remainder due under the terms of the lease to the contractual date of expiration. Less clear is whether the landlord can include and enforce a liquidated damages clause in connection with a continuous operation provision.
In El Centro Mall, the court faced the tenant's effort to avoid enforcement of just such a provision. Payless ShoeSource, a nationally known, budget priced shoe retailer, leased store space at the El Centro Mall (ECM) beginning in 1990. The lease terms called for a base monthly rent plus a "percentage rental" based on Payless' gross receipts. The lease contained an express covenant for continuous operation. The covenant required not only payment of the remaining rent and estimated percentage rental, but also a daily charge of $0.10 per square foot of rented space (with a minimum of $100) for each day Payless was not in operation.
Payless closed in March 2005. It continued to pay the base rent, CAM charges and taxes through lease end (December 31, 2005), but declined to pay the liquidated damages amount. (Percentage rent was not due or in dispute because of lagging sales.) Payless argued the liquidated damages provision was a penalty, arbitrary and unreasonable, and therefore unenforceable. The trial court did not agree, awarding ECM $90,226.80 in liquidated damages. Payless appealed.
Since there was no dispute about the propriety of the covenant for continuous operation, the Court of Appeal focused exclusively on the liquidated damages provision. The court observed that since 1977, such provisions in a commercial contract have enjoyed a presumption of validity. See Civil Code §1671; see also El Centro Mall, 174 Cal.App.4th at 62-63 (citing Californians for Population Stabilization v. Hewlett-Packard Co., 58 Cal.App.4th 273, 279 (1997). Civil Code Section 1671(b) specifically provides: "[A] provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made." The statute effectively shifts the burden of proof to the challenger seeking to avoid the provision. El Centro Mall, at 63.
The examination of validity looks at the reasonableness of the provision at the time of creation, not in retrospect. The reviewing court must consider the relationship between the liquidated damages established in the contact and the anticipated range of potential harm; the relative bargaining power of the parties; whether the parties employed counsel; the anticipated issues of cost and convenience in proving actual damages; the potential problems in proving causation and foreseeability; and whether the provision is contained in a form contract. Ibid. (citing Cal. Law Revision Com., com. 9, West's Ann. Civ. Code (1985 Ed.) foll. § 1671, p. 498). See also, Weber, Lipshie & Co. v. Christian, 52 Cal.App.4th 645 (1997); 12 Miller & Starr, supra, § 34:37, p. 34-143. The court then applies a "reasonable endeavor" test: "The amount set as liquidated damages 'must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.'" El Centro Mall, at 63 (quoting Ridgley v. Topa Thrift & Loan Assn., 17 Cal.4th 970, 977 (1998)).
Payless argued that the liquidated damages provision was a penalty because it included reference to ECM's loss of the percentage rental payment. The court agreed, to a point, since the lease already provided a means of calculating the percentage rental in the event of a default. Therefore, to the extent the liquidated damages provision dealt with percentage rental, it was arbitrary and unnecessary and therefore intended to penalize. El Centro Mall, at 64. See also, Garrett v. Coast & Southern Fed. Sav. & Loan Assn, 9 Cal.3d 731 (1973).
However, ECM contended that the liquidated damages provision reflected much more than the percentage rent. Through expert testimony, ECM established damages resulting from "the anticipated loss of the synergy, goodwill and patronage Payless provides by continuing to operate in the retail center." Ibid. The expert showed how a nationally known tenant such as Payless draws customers to the mall, generating foot traffic for other stores and goodwill for the mall itself. The expert further explained that for this reason, covenants for continuous operation are customary in retail centers, and it is typical for those covenants to include a liquidated damages provision. Finally, the expert asserted that basing such liquidated damages provisions on the size of the store is appropriate given that larger stores, with more brands and merchandise, can generally generate more goodwill and foot traffic. That translates into complementary tenants and ultimately more percentage rent through others. Ibid at 64-65. Payless did not counter this evidence, nor did it provide a reasonable estimate of what the range of actual damages might have been at the time the parties contracted. Compare, Harbor Island Holdings v. Kim, 107 Cal.App.4th 790 (2003) (liquidated damages provision with no reasonable relationship to anticipated damages). Accordingly, it failed to meet its burden under Section 1671.
Payless also tried to argue that Sears, an anchor tenant in the mall, escaped its lease obligations without paying anything for loss of goodwill, synergy or patronage. At the same time, ECM required smaller, non-national tenants to pay greater liquidated damages, or in some cases the same as Payless even though they lacked national stature and appeal. According to Payless, this showed the arbitrariness of the provision such that it did not represent a reasonable estimate of future damages for breach. However, Payless did not provide substantial evidence to support this claim, including whether there were extenuating circumstances that might explain why Sears was not similarly exposed, or whether some of the smaller, non-national stores actually generated more foot traffic per square foot. The court therefore rejected the argument. Ibid at 65.
El Centro Mall provides instruction for both sides on how to address enforcement of a liquidated damages provision in connection with a continuous operations clause. Generally, it shows the steps the court will go through in analyzing the provision. In addition, for landlords, it shows that a well crafted provision enjoys statutory protection if carefully drawn and supported by expert testimony displaying a rational basis for the damages. For tenants, it shows that reliance on argument is simply not enough. The field is tilted in favor of landlords by statute, and the tenant must be prepared to counter the landlord's claim with evidence, including expert testimony where appropriate, and proof that circumstances with other tenants are directly comparable and not subject to distinguishing factors.
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