Background

Typical clause profile

These clauses appear in commercial, retail and industrial leases drawn by most firms. There is no standard form of such clauses. Instead, the drafting varies widely in terms of the triggers and construction. The point in common is that the clauses all provide a payment obligation triggered only by tenant default. Typically, the clauses purport to be triggered by any failure to comply with a wide range of lease expiry obligations including:

  • removal of alterations and make good;
  • maintenance and repair obligations;
  • removal of goods; and
  • cleaning.

The clauses seek to provide a continuing payment obligation equivalent to rent even though the lease has ended, the keys have been returned to the landlord and the landlord enjoys possession of the premises.

Typically, the clauses are expressed to operate as one of the following:

  • liquidated damages at a daily rate equivalent to the rent and outgoings that were payable on the last day of the term;
  • a “deemed” licence for the period after the lease expiry at a licence fee equal to the daily rate of rent previously payable and otherwise on the same terms as the lease;
  • a “deemed” continuation or overholding of the lease after the expiry date otherwise agreed.

However described, the clauses provide a payment obligation that is only triggered by breach or default and, so, the clauses are subject to the rule against penalties.

Rule against penalties

The seminal statement of the rule against penalties was given in Dunlop Pneumatic Tyre Co. Ltd vs New Garage and Motor Co. Ltd [1915] AC 79. In essence, a payment obligation triggered by default is unenforceable unless the amount is a genuine pre estimate of loss. Payment obligations that are intended to intimidate amount to a penalty and are unenforceable.

The decision in Dunlop provided various tests including the following

  1. there is a presumption that a payment obligation amounts to a penalty where a single sum applies to multiple events some of which are serious and some of which are trivial; and
  2. whether the amount is penal depends upon whether it is “unconscionable compared to the greatest loss that could conceivably be suffered”.

The High Court has confirmed in various decisions that Dunlop represents the law in Australia, although the modern emphasis is to ask whether the agreed sum is “out of all proportion to the loss” that may be suffered. This formulation requires more than the amount lacking proportion to the loss, it must be “out of all” proportion.

The test is applied to a provision at the time the contract is made, not to the circumstances that, ultimately, transpire. This point is important, as it does not matter that the clause only works in the particular circumstances to allow recovery of damages equivalent to the loss that is incurred (nor that the clause is administered in a way to achieve this outcome). Either the clause is penal at the outset, and unenforceable, or it is not.

Application of the rule

In the writer’s view, the typical lease expiry provisions referred to arguably fail under both the tests set out above. The key reason is that the damages apply to a broad range of breaches without any materiality test or reasonableness requirement.

For example, for so long as major items of fit out are not removed, the tenant must continue to pay a sum equivalent to rent but the landlord has possession of (and may derive income from) the premises. If this was the sole trigger, this payment obligation ought to be enforceable because the premises may commercially be untenantable (so the amount payable is a reasonable pre-estimate). The agreed damages in those circumstances are not out of all proportion to the loss that may be suffered.

The arguable defect lies in the fact that the same result applies to the failure to remove the last picture hook or to clear the last scrap of rubbish as it does to the failure to materially comply with the obligation to remove major items of fitout. Also, within each of the triggers, no materiality test is provided. There is no carve out for minor breaches or non compliance, so that material and trivial breaches attract the same consequence.

As drawn, arguably the clauses both:

  1. attract the assumption of a penalty by applying the same agreed damages to breaches material and breaches trivial; and
  2. in the context of those trivial breaches, the sum is out of all proportion to the loss. Clearly, a landlord should not be compensated indefinitely at a rate equivalent to rent for a failure to pull out the last picture hook

The writer is not aware of any decision directly applying the doctrine of penalties to clauses of the type mentioned. Though the ultimate enforceability of any such clause in any particular lease must always be uncertain unless and until the clause is tested in court, such clauses have the advantage of concentrating the tenant’s mind on the consequences of breaching the lease. However some clauses of this type are better drawn than others,and the better drawn the clause, the greater will be the landlord’s peace of mind. What can be done? Landlords can review their standard leases to identify clauses that provide a payment obligation triggered by a default (however described). It may be possible for these to be redrawn so as to be less prone to attract the rule against penalties.