The Queensland Supreme Court has concluded that a clawback provision in an incentive deed (requiring the tenant to repay a proportion of the landlord’s fit out contribution and all rent rebates if the lease was terminated) was a penalty and therefore unenforceable[1]

The decision has wide application and means that, where a lease is terminated for a tenant’s default, the landlord’s remedy will usually be to sue for the cost of re-leasing the premises and lost rent rather than recovery of an up-front inducement or incentive. In light of the decision, Landlords will need to consider how to structure lease incentives and whether to persist with clawback provisions.

Background

The decision involved a commercial office lease for a term of 7 years (with options). The lessor gave an incentive comprising:

  • an agreed lump sum to be allowed as a rent abatement during the first 3 years
  • a contribution towards fitting out the premises (with the landlord to retain ownership of items it paid for with the contribution).

The incentives were documented in a separate incentive deed. This stated that if the lease was terminated before the end of the term (other than as a result of the landlord’s breach) the tenant would repay the abatement and a proportion of the fitout contribution based on the number of days remaining until the end of the initial term. 

The tenant abandoned the premises in breach of the lease 2½ years after commencement. As the tenant had gone into liquidation and the guarantors had been released from liability under the lease, the landlord sued the guarantors under the repayment clause in the incentive deed for $1.2m.The law of damages for breach

Generally, a party which breaches a contract (including a lease) is required to pay compensation to the other party so it would be in the same position as if the lease had been performed. Typically, in the case of a lease, this would mean paying the landlord:

  • the rent that would have been payable under the lease for the period during which the premises are vacant;
  • the cost of re-leasing the premises (potentially including market incentives payable to secure a new tenant and make good costs if the premises could not be let with the existing fitout); and
  • any shortfall in the rent payable by the new tenant.

This is subject to the landlord’s duty to mitigate its loss which requires it to make reasonable efforts to re-let the premises as quickly as possible for the best rent reasonably available.

The law regards a clause as a penalty (and unenforceable) if it requires a party which breaches a contract to pay an amount that is extravagant and unconscionable compared to the maximum loss that could be suffered by the other party.

How does this apply to incentive repayment clauses?

The Court decided the effect of the incentive repayment clause in this case was that, in addition to damages for breach of the lease, the landlord could recover money that it would not have otherwise received if the lease had not been terminated. It therefore purported to place the landlord in a much better position than if the lease had been performed. As the amount of the repayment was substantially in excess of the amount recoverable at law, the clause amounted to a penalty and was unenforceable.

The Court rejected a number of technical arguments by the landlord that, because of the way the incentive payment was documented, the rules about penalties did not apply. This is important because it demonstrates it is difficult to overcome the result merely by clever drafting.

The first argument was that the rules about penalties did not apply because the repayment clause did not apply only where the lease was terminated for the tenant’s breach, but also in other situations such as termination on damage or resumption of the premises.

The second was that the incentive agreement was a separate deal to the lease and the incentive was given conditionally on the tenant performing the lease for the agreed term. As the tenant had not fulfilled the condition, the landlord was entitled to repayment.

The third was that the lease imposed an obligation to pay a higher amount with an indulgence while the lease remained on foot.

These arguments were rejected because the incentive was paid to induce the tenant to take the lease. The lease and incentive agreement were part of the same deal and were to be read together. The real effect of the repayment clause was to require the tenant to make a payment if the lease was terminated for breach.