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Staying Out Of The Penalty Box: New Appellate Court Decision Provides Intriguing New Angle On What Constitutes An Unenforceable Penalty

The Second Appellate District of the California Court of Appeal recently issued a decision in Constellation-F, LLC v. World Trading 23, Inc. finding that a holdover provision in a commercial lease providing for significantly increased rents during the holdover period is not an unenforceable penalty under California Civil Code section 1671.  While this decision directly implicates holdover provisions in commercial leases, its broad language focusing on the contracting parties' respective bargaining powers may implicate other contractual relationships.

UNENFORCEABLE PENALTIES IN CALIFORNIA

California law, as codified in Civil Code Section 1671, generally provides that contractual liquidated damages provisions are unenforceable if the terms do not reflect a reasonable estimate of potential future damages under the circumstances which existed at the time the contract was formed. In most cases, the party challenging the contractual provision bears the burden of proving the provision is unreasonable.

This law is most commonly invoked by borrowers challenging the imposition of prepayment penalties, late charges, or default interest by their lenders, but has also been raised in other contexts with mixed results. The Second District, however, has now taken a novel approach that dispenses with the standard analysis under Section 1671 and instead focuses on the relative bargaining power of the parties.

HOLDOVER RENTS ARE NOT LIQUIDATED DAMAGES AND ARE NOT BARRED BY CIVIL CODE SECTION 1671

In Constellation-F, the parties disputed the enforceability of a holdover rent provision providing for an increase in base rent by 150% in the event tenant failed to vacate the premises following lease termination. Tenant successfully challenged the provision at trial, arguing it was an unenforceable penalty barred by Civil Code Section 1671.

On appeal, the majority of the court reversed the trial court's decision, finding that the holdover rent provision was enforceable. In so holding, the court cited Vucinich v. Gordon (a 1942 appellate decision) for its finding that holdover rents, or "graduated rents," are not "damages" governed by Section 1671 but simply reflect additional rents negotiated by parties in arms-length dealings. The court further explained that the policy underlying Section 1671 limits its application to combating "unfair and unreasonable coercion arising from an imbalance of bargaining power." The tenant's burden, according to the court, was to prove that the landlord had "market power," which the majority broadly analogized to the power exerted by monopolists oppressing consumers, and that tenant therefore had no competitive alternative to signing the lease at issue. Based on the absence of any evidence that the landlord had such monopolistic power, the majority determined that Section 1671 did not apply and the holdover rent provision was therefore valid and enforceable.

Notably, the dissenting opinion in Constellation-F strongly objected to the majority's holding on the issue, citing long-recognized California Supreme Court decisions in Ridgley v. Topa Thrift & Loan Assn. and Garrett v. Coast & Southern Fed. Sav. & Loan Assn.  These cases, which the majority distinguished on the grounds that they did not involve holdover rent provisions, involved challenges to late payment and default interest provisions in loans and established the generally accepted test to determine enforceability under Section 1671 - whether the charges imposed bear any rational relation to anticipated harm. The dissent in Constellation-F heavily criticized the majority's decision as a departure from established California law, perhaps foreshadowing a petition for review to the California Supreme Court.

BROADER IMPLICATIONS OF CONSTELLATION-F

Constellation-F clearly sets a new guidepost when it comes to the enforceability of holdover rent provisions in commercial leases. However, it is important to note that Constellation-F was decided in the context of an action for damages for breach of lease, not an action for unlawful detainer. Thus, the court did not decide whether the holdover rent would qualify as "rent" for purposes of a 3-day notice to pay rent or quit under Code of Civil Procedure (CCP) § 1161(1) or whether it would require a separate notice for breach of covenant (CCP § 1161(3)), nor did the court address case law limiting the "actual damages" a landlord may recover under CCP § 1174(b) for wrongful holdover in an eviction action to the reasonable rental value of the premises. How courts apply Constellation-F in unlawful detainer actions remains to be seen.

It also remains unclear how the decision may be applied in other settings, assuming it avoids or survives further appeal, and how it may affect parties' contracting strategy in the future. Will lenders rephrase default interest provisions to avoid any implication that they relate to damages? Will parties start including representations concerning equal bargaining power or the existence of competitive alternatives? If Constellation-F remains good law, parties seeking to impose these kinds of post-default provisions will certainly adjust their contracts accordingly.

Stay tuned to see whether Constellation-F represents a fundamental shift in how California courts apply, or decide not to apply, Civil Code Section 1671 to post-default charges in contracts.

© 2010-2020 Allen Matkins Leck Gamble Mallory & Natsis LLP National Law Review, Volume X, Number 49

TRENDING LEGAL ANALYSIS


About this Author

Michael Farrell Attorney at Allen Matkins
Partner

Michael R. Farrell is a partner in our Los Angeles office, where his practice focuses on litigation with an emphasis on real estate, secured transactions, and state and federal receiverships. Mike represents a wide range of clients including institutional lenders, banks, asset managers, receivers, individuals and various business entities.

Mike's practice includes the representation of lenders, owners, asset managers and investors in all aspects of real estate litigation, including pursuit of lender remedies against borrowers, guarantors and...

213-955-5527
Tim C. Hsu, Commercial Litigator, Litigation Associate, Allen Matkins Law Firm
Partner

Tim Hsu has significant experience in the financial services arena. In addition to being a lawyer, he is a California licensed Certified Public Accountant who has worked with publicly traded companies in audit, compliance, and reporting. This perspective informs his legal counsel to clients, and in his law practice, he represents clients with issues involving bankruptcy and creditors' rights, federal and state court receiverships, environmental disputes, and commercial litigation.

His experience and perspective allow him to thoroughly analyze complex legal issues and financial transactions and deliver practical guidance to his clients, setting them up for success in litigation. Tim’s accomplishments include successfully crafting and arguing multiple novel issues involving environmental and creditors' rights law on appeal and serving as part of various legal teams assisting receiver clients investigate and recover hundreds of millions of dollars for victims of fraud. He recently assisted a receivership client with investigation and pursuit of hundreds of disgorgement claims arising from profits paid out of a Ponzi scheme. Additionally, Tim successfully crafted a legal argument on a disputed issue of law that was upheld on appeal in the 9th Circuit Court of Appeals, resulting in a judgment in favor of his client.

Tim’s practice focuses on litigation, including general commercial litigation, lender and financial services litigation, and environmental claims litigation brought under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA). He also has experience representing lenders in financial transactions, including secured credit transactions.

Prior to becoming a lawyer, Tim was a senior financial statement auditor with PricewaterhouseCoopers, LLP, and was an assistant fund controller at the Capital Group Companies. He began his legal career as a Judicial Extern for Magistrate Judge Oswald Parada in the United States District Court, Central District of California, where he reviewed and analyzed statutes, regulations, and case law addressing substantive and procedural issues arising in civil rights, habeas corpus, and Social Security Administration benefits appeals matters.

Tim is actively involved in the Chinese-American financial community as a member of the Chinese American CPA Association, and he is an executive member of the Remedies section of the Los Angeles County Bar Association.

213-955-5516