Holdover Provisions Hold On For One More Day

Most leases contain a holdover provision that states if the tenant fails to vacate on time (i.e., holds over beyond the expiration or termination of the lease), the rent payable by the tenant will automatically increase, typically to 150% or 200% of the prior month’s rent.  This provision is necessary to help protect landlords because in most jurisdictions, if a tenant promises to vacate the premises by a certain date and breaks that promise, the landlord does not have the right to physically remove the tenant or to lock the doors and recover possession of the premises on its own.  Instead, the landlord must go through a complex legal process that often takes several months—and in some cases more than a year—to recover possession of its property.  The idea of imposing a substantial rent increase is to create a large enough incentive (some would say penalty) for the tenant to timely vacate so that the landlord is not forced to go through a costly and protracted lawsuit that could cause the landlord to lose out on a potential new deal or incur other damages.

Due to various statutes and case law that prohibit imposing penalties in contracts, real estate attorneys take great care to identify holdover provisions as something other than a penalty—typically, a lease will simply state that the rent increases to a certain amount in the event of a holdover, without giving any further reason for the increase.  On the business side, real estate experts have long believed that courts will enforce these provisions because it is the custom and practice within the industry.  Those on the legal side have relied on the enforceability of these provisions based on the legal principle of liquidated damages (in other words, the increase to 150% or 200% of the prior month’s rent—an increase that only applies if the tenant holds over—is meant to reimburse the landlord for the damages that the landlord is anticipated to suffer if the tenant holds over).  Under this legal principle, holdover damages are enforceable as liquidated damages so long as actual damages were too difficult to predict at the time the lease was made and the damages bear a reasonable relationship to the anticipated harm that the landlord would likely suffer from a holdover.  For example, it would not be reasonable to say that the tenant would owe $1,000,000 if it overstays its lease where the rent was merely $10 per month.

A recent case could turn the conventional view of holdover provisions on its head[1].  In Constellation-F, LLC v. World Trading 23, Inc. (Cal. Ct. App., Feb. 7, 2020, No. B293033), the majority ruled that holdover provisions are neither liquidated damages nor a penalty, but rather “graduated rent,” a term borrowed from Vucinich v. Gordon, 51 Cal.App.2d 434, a 1942 decision that held a holdover provision charging the tenant 500% of the prior rent was enforceable.  As “graduated rent,” the Constellation-F court held that such a provision is enforceable unless the tenant can show that the landlord was guilty of oppressive coercion arising from an imbalance of bargaining power, in which case liquidated damage principles would apply.  The court then concluded that the facts did not support a showing of coercion because the tenant failed to show that the landlord had monopoly power to set the price of rent and the tenant was not without a competitive alternative.  The court added, “[Tenant] was at complete liberty to avoid the higher rent.  It had merely to leave” (Constellation-F, page 8).

The case, however, includes a strong dissent that is more (although not entirely) consistent with the prior conventional wisdom, leaving matters unpredictable for real estate lawyers.  The dissent argued that established case law dictates that holdover provisions should be viewed as liquidated damages and should only be enforced so long as the provision was reasonable under the circumstances existing at the time the lease was made.  Criticizing the majority’s holding, the dissenting opinion stated that “[u]nder the majority’s new test, contracting parties need not attempt to tether a liquidated damages provision to estimated anticipated losses; instead a challenger must analyze each contracting party’s respective market power and persuade a court there was enough of an imbalance of market power between the parties to invalidate the damages provision”  (Constellation-F, Dissent page 1).  Had the dissent stopped there, it likely would have garnered strong support in the leasing industry; however, the dissent went on to find that the holdover provision in this case should be unenforceable because the landlord neither proved that the parties took up the effort to predict damages before signing the lease nor established that the damages were impractical or extremely difficult to fix.  We believe a better view would have been to accept, as a matter of law, that 150% holdover rent bears a reasonable relationship to a landlord’s anticipated damages, and that fixing holdover damages is impractical or extremely difficult.

Based on this ruling, aggressive landlords may want to update their leases.  Under the majority’s logic, holdover provisions that charge as high as a 500% “graduated rent” (if not higher) should be enforceable so long as the landlord does not have a monopoly on the real estate market.  We are not rushing to revise our leases just yet though; while it is one thing to enforce a 150% holdover provision under the logic of “graduated rent”, it is quite another to predict whether a court will enforce a substantially bigger penalty rent increase under similar circumstances.

[1] The result may stay the same however, given that the court still concluded that the holdover provision imposing 150% rent was enforceable, albeit for unexpected reasons.

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