Liquidated damages clauses can be a convenient way to incentivize performance and avoid disputes over the price tag of breaches. One common use of such clauses is to require the tenant to pay predetermined rent increases in the event it violates a covenant not to open a competing business within a specific radius of the leased property. But getting courts to enforce such a provision can be difficult, as illustrated by the scenario below.  

THE LEASE

The steakhouse chain Del Frisco’s (DF) leases space for a restaurant in a mixed-use commercial development in Texas. The lease bans DF from operating a “Competing Business” within a five-mile radius of the property. Anticipating losses of about $350,000 in the event of a breach, the landlord provides for rent escalations in the event DF opens and continues to operate a Competing Business in the restricted radius of:

• 110 percent of the minimum base rent; and
• Percentage rent based on 125 percent of gross sales (which escalates to 175 percent if the Competing Business is within a two-mile radius).

After laying out the escalation formula, the lease includes the following clause:

The above adjustment in rental reflects the estimate of the parties as to the damages which Landlord would be likely to incur by reason of the diversion of business and customer traffic from the Demised Premises and Project to such other store within the Restricted Area, as a proximate result of the establishment of a Competing Business.

WHAT HAPPENED

Less than six months after signing the lease, the tenant leases property for a DF Grille in a competing mixed-use complex less than two miles away. The landlord gets wind of the new lease and demands that DF pay the adjusted rent for opening a Competing Business. DF refuses. The new restaurant isn’t a Competing Business, it insists. And even if it were, the rent adjustment clause is an unenforceable liquidated damages provision.  

QUESTION

Assuming the new restaurant is a Competing Business, does DF have to pay the rent increase?

A.            No, because the rent increase is an impermissible penalty.

B.            Yes, because the adjustment amount is a reasonable estimate of the landlord’s damages.

C.            No, because liquidated damages clauses are illegal in Texas.

D.            Yes, because the Competing Business ban is a valid restriction on the tenant’s use of the property.

ANSWER

A. The rent adjustment is invalid because it operates as an impermissible penalty.

EXPLANATION

Rule of thumb: Liquidated damages clauses are enforceable only if they reasonably estimate the losses that the non-breaching party would incur as a result of the other party’s breach; they’re unenforceable if they impose a penalty on the party committing the breach. The landlord in this scenario, which is based on an actual case called The Shops at Legacy (RPAI) L.P. v. Del Frisco's Grille of Tex., LLC (2020 Tex. App. LEXIS 6571), clearly understood the rules and tried to draft the rent adjustment clauses accordingly. But it didn’t work.

The landlord’s first mistake was characterizing the rent adjustment as an estimate of the “damages” it would likely incur if DF opened a Competing Business nearby. This cut the legs out from the landlord’s claim that the increase was nothing more than a mutually agreed-to rent adjustment. “Calling the damages a ‘rent adjustment’ does not change” the fact that the landlord’s clear intent was to make DF pay damages to compensate for its anticipated losses to its businesses, the court reasoned. So, A is the right answer.

WHY WRONG ANSWERS ARE WRONG

B is wrong because there was no evidence supporting the landlord’s estimate that it would lose about $350,000 as a result of DF’s opening a Competing Business. In fact, DF produced evidence showing that the new restaurant had no impact on the tenant restaurant’s sales.

C is wrong because, as in most states, liquidated damages clauses are generally enforceable in Texas, provided that they represent a reasonable estimate of damages and don’t operate as a penalty. The clause in this case failed because it didn’t meet those standards.

D is wrong because while it’s true that landlords do have the right to restrict how tenants use the property, the Competing Business ban and resulting rent adjustment for breach pertained to the tenant’s parent company, namely DF and the operation of its restaurant business rather than the restaurant tenant’s actual use or occupation of the property.

TAKEAWAY: 5 WAYS TO MAKE LIQUIDATED DAMAGES CLAUSES MORE ENFORCEABLE

In addition to going to school on the mistakes made by the landlord in the Del Frisco’s Grille case, here are five drafting tips, as well as a Model Lease Clause: Set Rent Escalation as Liquidated Damages for Tenant’s Breach of Radius Restriction, you can use to bolster the enforceability of your own liquidated damages clauses.

1. Call it a “liquidated damages” clause. While courts won’t enforce the clause merely because you call it “liquidated damages,” using the term at least clarifies intent; for the same reason, don’t refer to the provision as a “penalty.”

2. Steer clear of “shotgun” clauses. Courts won’t enforce so called “shotgun” clauses purporting to provide for the same liquidated damages amount for multiple kinds of breaches that aren’t all equally serious. Instead, individually tailor each liquidated damages clause so that the stipulated sum is appropriate for the particular type of breach.

3. Steer clear of “actual damages x multiple” formulas. In some states, including Texas, liquidated damages based on multiples of actual damages—for example, unpaid rent amount x 3, are deemed illegal as a matter of law. The same is true of formulas purporting to add specific amounts to actual damages—for example, unpaid rent + $10,000 per month.

4. Include “recitals.” Although the tactic didn’t work in the Del Frisco’s Grille case, it sometimes helps to include recitals acknowledging that “actual damages are uncertain and would be difficult to ascertain,” and that both parties agree that the stipulated liquidated damages sum “constitutes reasonable compensation in the event of a breach” and is “not intended as a penalty.”

5. Consider a bonus for early performance instead. You can avoid liquidated damages controversies completely by offering bonuses or premiums for early performance as an alternative. For example, where a $500 per day penalty for delayed performance may be unenforceable, moving the performance date back 10 days and offering a $500 per day bonus for each day the performance is completed early may be less problematic.