Surrender Agreements: Don’t Surrender Your Contractual Rights!December 3, 2020
New York courts, citing public policy grounds, often decline to enforce contractual liquidated damages provisions that assess damages for noncompliance in a manner grossly disproportionate to foreseeable losses. On November 24, 2020, in a divided decision, New York State's highest court struck a damages provision in a heavily negotiated surrender agreement between “two New York City icons.” The decision has important practical implications for drafting effective and enforceable surrender agreements. See Trustees of Columbia University in City of New York v. D'Agostino Supermarkets, Inc., --- N.E.3d ----, 2020 WL 6875988 (N.Y. Nov. 24, 2020).
Lease surrender agreements come into play in a variety of circumstances and may be triggered by the needs of either party to the lease to end the term before its scheduled expiration. Herrick frequently represents both landlords and tenants in surrender agreements involving office, retail and other types of commercial space.
Where a property owner desires to develop property that is leased to tenants, it may structure a surrender agreement to terminate the tenancy upon execution, grant tenant a license to use the premises through an agreed-upon termination date aligned with owner’s development schedule, provide for issuance of an immediate warrant of eviction stayed through the termination date, and enable the tenant to earn a hefty surrender payment only if it timely vacates by the termination date, time being of the essence. For example, in 154-7th Ave. Chelsea, Inc., v. Ballaghaderreen Corp., 2018 WL 1536626 (Sup. Ct. N.Y. Cnty. March 29, 2018), Herrick prevailed in an action to enforce the strict terms of a surrender agreement it drafted on behalf of a building owner for prime retail space in Manhattan’s Chelsea neighborhood. On summary judgment, the trial court determined that the commercial tenant breached its contractual obligation to timely vacate the owner’s prime, street level space, ordered the return of an unearned termination fee totaling $1 million, and awarded interest and attorneys’ fees to the landlord.
In other situations, a struggling tenant may desire to terminate its lease early in exchange for payment of a termination payment to its landlord amounting to less than it would otherwise have to pay under the lease, while affording the landlord the right to reenter the premises for purposes of entering into a new lease with another tenant. In the era of COVID-19, Herrick has seen a significant increase early termination agreements. Some landlords believe they will be in a better position by accepting a smaller lump sum termination payment while recovering legal possession of space, without the uncertainty inherent in bringing legal action before a potentially unsympathetic court against a tenant who may not have the ability to pay. However, sometimes, as in the D’Agostino case, the tenant may want to negotiate a payout term in lieu of a lump sum payment. This creates a risk that the landlord will forfeit its right to collect future rents for breaches of the lease without being paid the negotiated settlement amount. Accordingly, as demonstrated by the recent D’Agostino decision, a well-drafted surrender agreement is essential.
D'Agostino agreed to rent space from Columbia to be used as a supermarket. Beginning in 2016, D'Agostino stopped paying rent under its lease. With a little over two years remaining on the lease, the parties entered into a surrender agreement in which D'Agostino agreed to surrender possession of the premises and make surrender payments totaling over $260,000. The surrender agreement provided that if D'Agostino failed to make any of the payments within five days of receiving a notice of default, then D’Agostino would not “be released and relieved” from the claims, and the aggregate of all rents and other sums under the terminated lease would become due. D'Agostino vacated and surrendered the premises upon signing the Surrender Agreement and timely made two $43,000 surrender payments. Columbia relet the premises one month after the surrender. But, D'Agostino failed to timely pay monthly surrender payments due thereafter, despite Columbia’s notice to cure. Columbia commenced the action seeking in excess of $1 million, plus interest. D'Agostino attempted to tender the outstanding amount due under the surrender agreement of approximately $175,000, Columbia rejected the tender, and D’Agostino cross-moved for summary judgment striking the liquidated damages provision in the surrender agreement.
The Supreme Court and Appellate Division, First Department, sided with D’Agostino. In a 4:3 decision, a divided Court of Appeals affirmed, holding that the penalizing nature of the liquidated damages provision was an unenforceable penalty because it amounted to damages grossly disproportionate to Columbia’s actual losses due to the breach of the surrender agreement: “By any measure the more than one million dollars plus interest demanded here is disproportionate to the $175,571.73 unpaid under the Surrender Agreement.” Reinstating D’Agostino’s future rent liabilities under the terminated lease would require the payment of damages effectively 7 ½ times what Columbia would have received if D’Agostino had fully complied with the surrender agreement. Notably, the Court measured Columbia’s damages against D’Agostino’s breach of the surrender agreement and not against D’Agostino’s previous breach of the lease. The Court maintained that the Surrender Agreement constituted a new contract that superseded the lease.
In a well-reasoned dissent, Chief Judge DiFiore maintained that the majority adopted an overly simplistic view of a surrender agreement that failed to enforce New York’s public policy favoring the strict enforcement of settlement agreements or apply New York’s strong freedom of contract precedent affording commercial certainty in real property transactions. The dissent maintained that the remedy provision in the settlement agreement should be viewed as a component of a settlement after a breach, not as a liquidated damages clause crafted at the beginning of a contractual relationship. The dissent explained that the parties understood that D’Agostino’s liability for breach of the lease was much greater than the value of the surrender payments, and the obligations triggered if those payments were not timely made were designed to compensate Columbia for D’Agostino’s earlier breach of lease. The dissent also cautioned that the majority’s decision could have a chilling effect on future efforts to resolve lease disputes without litigation to the detriment of defaulting tenants.
After D’Agostino, landlords may question the benefit of contracting with defaulted tenants if their recovery is limited to the discounted amount provided for in the restructured contract. As the dissent maintained, the majority’s decision would permit defaulted tenants to default again without recourse. As is evident from the D’Agostino case, whether a surrender agreement is structured as a settlement in connection with a defaulted lease or as a voluntary transaction of freely contracting parties may define the scope of relief available in the event of a breach. A carefully and creatively drafted surrender agreement can help parties maximize their recourse if their expectations are not fulfilled.
If you have questions about your leasehold rights and obligations, please reach out to Michael Berengarten and Dena Cohen.
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© 2020 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.