As a general rule, courts do not save sophisticated parties from bad deals; instead, courts enforce both good deals and bad deals between sophisticated parties according to the express terms set forth in a written contract.[1] New York is particularly prone to upholding these freedom of contract principles because freedom of contract avoids “judicial upending of the balance struck at the conclusion of the parties’ negotiations,” as well as “promotes certainty and predictability and respects the autonomy of commercial parties in ordering their own business arrangements.”[2] But most general rules have their exceptions. And a recent decision by New York’s highest court, The Trustees of Columbia University v. D’Agostino Supermarkets, Inc., 2020 WL 6875988 (N.Y. Nov. 24, 2020), illustrates the application of one of those exceptions to the otherwise strong policy favoring freedom of contract—unenforceable penalties for breach of contract.
Columbia University involved a dispute over the agreed remedy for a breach of the terms of a Surrender Agreement between a landlord and tenant respecting a long-term lease. The tenant had become in arrears in the payment of rent under its lease. Pursuant to the terms of the lease, the tenant was liable for all past due rent and the continued payment of all future rent during the remaining term of the lease. Rather than insist on holding the tenant to the terms of the lease and leaving the tenant in possession of the premises, however, the landlord agreed to enter into a Surrender Agreement whereby the tenant surrendered possession of the leased premise to the landlord, the lease was terminated, the tenant agreed to pay, in installments, a specified amount equal to the rent then currently in arrears (the “Settlement Amount”), and the landlord released the tenant from all claims for past due or future rent. To encourage the tenant to promptly pay all installments of the Settlement Amount, the Surrender Agreement provided that if the tenant failed to timely pay any of the agreed installments of the Settlement Amount, the tenant would no longer have the benefit of the release of claims and the tenant would be obligated to pay the landlord the aggregate amount of all unpaid rent originally payable under the lease for the entire term, without discounting that future rental amount to present value and without taking into account any benefit the landlord may obtain from re-leasing the premises (the “Surrender Default Remedy”). The amount of the payment required pursuant to the Surrender Default Remedy was more than seven times the Settlement Amount (there was approximately two years remaining on the original lease term at the time the Surrender Agreement was signed). Just as the tenant had become in arrears of its rental obligations under the original lease, the tenant missed four installments of the Settlement Amount. When the tenant failed to cure the nonpayment of those installments, the landlord sued to enforce the Surrender Default Remedy. The tenant then tried to tender payment of the full Settlement Amount, but the landlord refused, insisting that it was now owed the full future aggregate rent amount under the original lease pursuant to the Surrender Default Remedy. The trial court refused to enforce the Surrender Default Remedy and granted summary judgment in favor of the tenant, thereby limiting the landlord’s recovery to the unpaid Settlement Amount, plus interest. The intermediate appellate court affirmed the trial court’s decision. And in a 4-3 decision, the New York Court of Appeals also affirmed the trial court’s decision, declaring that the Settlement Default Remedy was an unenforceable penalty.
The common law has long had a problem with anything that forced or “terrorized”[3] a party into performing a contract. Indeed, “[t]he modern law of contract damages is based on the premise that a contractual obligation is not necessarily an obligation to perform, but rather an obligation to choose between performance and compensatory damages.”[4] And there are circumstances (i.e., the so-called “efficient breach”) in which the common law actually encourages the breach of an uneconomic contract and the payment of compensatory damages to the innocent party, rather than continued performance.[5]
Thus, clauses that seek to stipulate an agreed amount of damages that will be payable in the event a contract is breached in the future have always been greeted with concern by the common law courts. Traditionally, the approach was to test any clause stipulating a fixed damages amount to determine if it was true to the compensatory goal of damages for breach of contract, or if it was instead intended to penalize the breach and thus force performance. If it was the former, it was an enforceable liquidated damages provision, but if it was the latter, it was unenforceable penalty. The means of testing whether a clause is a legitimate liquidated damages provision consistent with the common law’s compensatory approach to damages for breach, or instead a clause intended to force performance by penalizing nonperformance, have varied and continue to vary among the U.S. states and other common law jurisdictions. But the basic test for the enforceability of a pre-agreed damages clause in most U.S. states is whether “the harm caused by the breach [of the contract] is incapable or difficult of estimation and … the amount of the [agreed] damages is a reasonable forecast of just compensation.”[6]
But many courts, including it seems those in New York, simply declare penal and unenforceable any contractual provision that requires the payment of damages that are “grossly disproportionate” to the actual damages that, at the time the contract is entered into, would reasonably be anticipated to arise from a future breach of the contract.[7] And in Columbia University, applying this test to the Settlement Default Remedy was, according to the majority, fairly straight forward. The breach in question was the breach of the tenant’s obligation to timely pay the installments of the Settlement Amount and requiring a payment of over seven times that amount upon default in the payment of those installments was clearly disproportionate and therefore constituted a penalty.
The dissent, however, saw things differently. The actual damages that the landlord might incur from the breach of the payment obligation under the Surrender Agreement was not the operative anticipated damages against which the disproportionate test should be applied...
