Private Equity

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. Instead, “an analysis of whether the damages set forth in the Surrender Agreement are grossly disproportionate to [the landlord’s] probable losses requires consideration not only of the value of the Surrender Payments that [the tenant] failed to make, but also of the probable damages already set in motion by [the tenant’s] prior breach of the lease, viewed from the time the Surrender Agreement was executed and not the date of the breach.”^[8] And tested against the damages that had already arisen under the original lease at the time the Surrender Agreement had been entered into, there was no disproportionality. In other words, the dissent saw the Surrender Agreement as having created a contingent discount of the amount of losses that the landlord might well have sought under the original lease at the time the Surrender Agreement was signed, provided that the tenant timely paid the discounted amount. The majority, on the other hand, saw the Surrender Agreement as an independent contract providing for installment payments of the Settlement Amount, with an agreed damages provision that was triggered upon a default in those installments. 

The dissent suggests that the parties’ intent was clear to structure the Surrender Agreement to provide for a conditional discount of the larger damages claim (with a conditional release of claims) as long as the tenant timely paid all installments of the Settlement Amount. But both parties referred to the Surrender Default Remedy as a liquidated damages provision. And it appeared to have been clearly triggered by the tenant’s default in timely paying, after notice and opportunity to cure, any of the installments of the Settlement Amount. And that distinction (between a contingent discount and agreed damages for failure to pay a discounted amount) actually may be important. A conditional primary obligation—i.e., you agree to pay me $100, provided that if you timely pay me $5 each month for the next 6 months, I agree to accept that $30 in satisfaction of the $100 obligation^[9]—is at least structurally different from an obligation to pay $30, in 6 equal installments of $5 each, but if you fail to timely pay me any such installment you now must pay me $100 (less any previously paid installments). In other words, might the result have been different in Columbia University if the Surrender Agreement had been expressly structured so that the Settlement Amount was the larger claim for all future rental payable under the lease, with a conditional discount of that amount if the agreed installments of the lesser amount were timely paid? Well, maybe.

According to Arthur L. Corbin, the late Yale law professor and leading American scholar on contract law, it is always important to distinguish between primary and secondary obligations created by contact:

The formation of a contract creates an original primary obligation. Upon breach of this primary obligation, there arises a secondary obligation to pay damages.”^[10]

And it is the secondary obligation to pay damages upon breach of the primary obligation that is the subject of the penalty rule, not the primary obligation itself—at least that is how it was historically understood by the English courts that gave birth to the penalty rule.^[11] So, for example, you might agree to pay a seller X dollars for a target company at closing, with an additional sum to be payable one year after closing provided that the seller complies with her non-compete. If the seller fails to comply with the non-compete, is the resulting loss of the additional purchase price subject to analysis under the penalty rule, or is it instead simply a purchase price adjustment mechanic that recognizes the value of the non-compete as part of the purchase of the business?^[12] And if there had been an actual acknowledgement by the tenant in Columbia University that it owed the entire future rental amount, and the Surrender Agreement had expressly stated that the larger sum was the agreed settlement amount, but that the tenant was entitled to a discount if it paid the lower amount within a specified period in installments, would that agreement have been outside the penalty rule? 

As far back as 1854, New York’s highest court declared that the penalty rule was a subject upon which “[t]he ablest judges have declared that they felt themselves embarrassed in ascertaining the principle on which the decisions … were founded.”^[13] And things have not gotten much clearer since. Indeed, in 2015, the U.K Supreme Court declared that “[t]he penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well.”^[14] So predicting answers to how and when the penalty rule may rear its head in private equity agreements is not the goal of this piece. But there are indications in some cases in the U.S., that structuring an agreement so that it is a conditional primary obligation rather than a secondary obligation to pay specified damages when that primary obligation is breached, may take the agreement outside the penalty versus liquidated damages question altogether. 

For example, in In re WM Distribution, Inc., 571 B.R. 866 (Bankr. D.N.M 2018), the parties settled a disputed claim of $6 million for an agreed amount of $1.3 million, payable in installments pursuant to a promissory note. Pursuant to the terms of the promissory note, the maker agreed to pay the sum of $600,000, in addition to the remaining principal sum of $1.3 million, if the maker defaulted on the note. When the maker in fact defaulted, the maker sought to declare the additional $600,000 payment as a penalty. The noteholder countered with arguments similar to those voiced by the dissent in Columbia University—i.e., the reasonableness of the $600,000 needed to be tested against their original claims ($6 million), not the $1.3 million note amount. But the court ruled that the $600,000 was a penalty because it was disproportionate to the anticipated damages that could arise from a default under the $1.3 note amount, and “[t]he $600,000 additional amount was [not] a discount given in settlement that was conditioned on payment of $1.3 million prior to the occurrence of an event of default of the type that triggered a $600,000 default remedy.” But helpfully, the court added that:

The parties could have agreed to a settlement in the amount of $1.9 million, with a $600,000 discount if [the maker] paid $1.3 million to [the noteholder] within a certain period of time or prior to [the maker] breaching any obligations under the Promissory Note. But that was not the agreement of the parties.

Similarly, in Red & White Distribution, LLC v. Osteroid Enterprises, LLC, 38 Cal.App.5th 582 (2019), the parties settled a disputed loan agreement that had a principle amount of $1.8 million, plus interest and attorney’s fees. The parties entered into a settlement agreement that provided that the borrower agreed to pay $2.1 million, plus interest, pursuant to a payment plan. According to the terms of the settlement agreement, in the event of a default by the borrower under the payment plan, the borrower would be obligated to pay the lender $2.8 million—i.e., there was a $700,000 difference between the agreed settlement amount and the amount that would be owed if the payment plan’s installments were not timely paid. Once again, the court held that the $700,000 was a penalty. But the court then added a helpful message: “We publish to remind practitioners whose clients settle a dispute involving payments over time how to incentivize prompt payment properly, and what may happen if done incorrectly.” And what should the lender have done to properly incentivize payment? According to the court:

[I]f the parties stipulate that the debt is a certain number, they may agree that it may be discharged for that number minus some amount. They may also agree that in the event the debtor does not timely make the agreed payments, a stipulated judgment may be entered for the full amount.

But that is not how the parties in this case structured their agreement. Despite the [lender’s] repeated claims to the contrary, nothing in the settlement agreement nor the appellate record demonstrates [borrower] admitted it owed $2.8 million. Rather, the settlement agreement states [borrower] is “liable to pay to the [lender] $2,100,000.00 (“Total Payment Plan Amount”) plus interest thereon ….” Had the parties intended to settle for $2.8 million, but apply a discount for timely payments, they could have done so expressly. The parties could have, but did not, include terms in the agreement stating [borrower] is liable to pay the [lender] $2.8 million, but so long as all payments are timely made in accordance with the payment schedule, the amount due shall be discounted to $2.1 million.

And in Mitsuwa Corp. v. Wehba, 2019 WL 3561928 (Cal. App. 2d Aug. 6, 2019) (unpublished), the parties did just that: entered into a settlement agreement regarding a defaulted loan that provided that the borrower agreed to pay $15 million, but that if the borrower timely paid two installments of $4 million and $6.5 million, the remaining $4.5 million would not be required to be paid. When the borrower defaulted and the lender sued for the entire remaining unpaid balance of the $15 million, the borrower argued that the additional $4.5 million was a penalty. But based on the structure of the settlement (a fixed agreed settlement of $15 million, with a discount for early payment), the court distinguished other penalty cases and determined that “provision of the Agreement requiring defendants to pay the full $15 million is neither liquidated damages nor a penalty.”^[15]

Does this suggest that properly structured (as an incentive rather than a penalty), the tenant could have been required to pay the full future rental amount upon failure to pay the installments of the Settlement Amount in Columbia University. Maybe, maybe not. The answer would probably depend on whether the landlord actually had a legitimate claim for that full amount as of the date the settlement was entered into, and whether the tenant in fact admitted that it owed that full amount.^[16] And the cases seem to suggest that a real acknowledgement of that amount as a debt owing is necessary, not a traditional statement that there is no admission of liability.^[17]

There simply are no clear answers here. But the common law’s penalty principles need to be carefully considered, together with possible structuring alternatives, in any transaction where performance is necessarily intended to be strongly encouraged, and where actual damages for failure to abide by an agreement may, in fact, be woefully inadequate.