Can a landlord recover lease incentives from a defaulting tenant or its guarantor?

The High Court decision in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 has renewed interest among lawyers in the legal doctrine of contractual ‘penalties’.  In GWC Property Group Pty Ltd v Higginson & Ors [2014] QSC 264, the Supreme Court of Queensland had to consider the issue of contractual penalties in relation to lease incentives and their attempted claw back by the landlord.

Background

In GWC Property Group Pty Ltd v Higginson & Ors, Dalton J of the Supreme Court of Queensland had to deal with the aftermath of the liquidation of an incorporated firm of solicitors.

There were three documents executed by the parties evidencing the arrangements:

(a)   The incorporated firm of solicitors had leased the premises, commencing on 11 November 2010 for a term of seven years, with three further options from the landlord’s predecessor in title;

(b)  The parties (the firm, the landlord’s predecessor and the guarantors) had executed a document described as an “Incentive Deed”; and

(c)   The defendants (as guarantors) had executed a guarantee of the debts and obligations of the firm to the landlord’ predecessor pursuant to both the lease and the Incentive Deed.

The landlord’s predecessor transferred the title to the landlord; in 2013, the landlord terminated the lease. The firm failed to repay the incentives on termination of the lease, in accordance with the terms of the deed. 

Claw back by landlord of incentives

There was no claim made against the firm under the Incentive Deed or the firm and the guarantors under the lease.

The case involved a claim by the landlord against the guarantors for repayment of the amount of incentives (of $1.2 million), which the firm received pursuant to the provisions of the Incentive Deed, as a part of the leasing arrangement, and failed to repay upon termination of the lease.

The Queensland Supreme Court decided (following Andrews v ANZ) that the attempted “claw back” of the incentives given to the firm was based upon “clauses which are wholly penal” (paragraph 51) and therefore they should not be enforced.

In her analysis, Dalton J rejected the plaintiff’s assertion that the sums claimed were not in fact penalties; rather, the plaintiff argued that the repayments it sought were properly viewed not as punitive payments on breach but as restitutionary repayments (paragraph 28). The Honourable Justice Dalton rejected this argument, on the basis (at paragraph 30):

… it seems to me that all three payments contended for by the plaintiff share the characteristic that had the tenant not breached the lease agreement, or had it breached the lease agreement only in ways which did not move the landlord to terminate, the sums of money claimed in this proceeding would never have been payable. These sums are not analogous to the acceleration of a delayed payment of monies which will eventually be paid if the contract is fully performed. … They are pecuniary obligations which will never arise except on termination.

  

At paragraph 33, Dalton J noted:

The plaintiff’s argument is simply that it is suing for a contractual sum due on a specified event. The difficulty is that the specified event is termination of the lease on breach by the tenant and, even on the pre-Andrews’ law, such a clause was subject to review as a penalty …

At paragraph 36, Dalton J noted:

The repayment clauses … of the Incentive Deed sought to give the landlord an advantage which it would not have had if the lease were performed according to its terms. Before the lease and Incentive Deed were signed the landlord was in the position that its potential tenant would contract only on the basis that it received abatements and a fit-out. The impugned clauses do not restore the landlord to that pre-contractual position; they give it an advantage which it would never have had if the lease had uneventfully run its term.

At paragraph 39, her Honour noted:  

To establish that they are penal, the defendants needed to show that the impugned clauses stipulated for repayments which were extravagant and unconscionable in comparison with the maximum loss that might be suffered on breach of contract. The test is an objective one not related to the parties’ states of mind. Matters are to be judged as at the time the contract was made.

She then concluded:

In my view the repayment clauses here do impose obligations which are substantially in excess of any genuine pre-estimate of damages. In addition to contractual damages for breach of the lease, the landlord was entitled, by the repayment clauses, to recover monies to which it would never have been entitled had the lease run its course. In effect, it was entitled to recover as though the tenant had agreed to the rent and signage fees without any abatement, and as though it had not been necessary for the landlord to pay the fit-out incentive in order to complete the bargain with the tenant. It is true that all three impugned clauses limit repayment to specified times, rather than require repayment for the whole period relevant to contractual damages. Nonetheless, the repayment clauses meant that on termination the landlord was entitled to damages for breach of the bargain it had made, and substantial additional payments by reference to a bargain it had not made.

[40] There was evidence on the application before me from a Mr Douglas on behalf of the plaintiff to the effect that the benefits given to the tenant by way of fit-out contribution and abatement in the Incentive Deed reflected prevailing market conditions. This is the very point. Only with those substantial financial concessions did the landlord obtain the lease it did. It is entitled to damages for breach of that lease but it is not entitled to extra payments on the basis that it might have obtained a higher price for its premises had the market conditions been better for it. It is not to the point that Mr Douglas opines that the fit-out may not be attractive to future tenants, or that future tenants might also require incentives such as those contained in the Incentive Deed. The parties’ bargain was that the landlord would own the fit-out. If the landlord has difficulty in re-letting the premises, that fact will be adequately reflected in its contractual damages.

Conclusion 

As readers will be aware, incentives in commercial leases in Victoria (and in most other parts of Australia) are now very common, and landlords have tried in various ways to protect those incentives from insolvent tenants.

The decision in this case confirms that the common law (and equitable) principles of penalties will have a serious effect upon a landlord's attempt to recover those incentives. 

Ultimately, the decision should force landlords to rethink the strategy of providing incentives to tenants up front. If the incentive cannot be recovered from a defaulting tenant, it may be commercially more sensible for the landlord to retain ownership of incentives such as fit outs, even if it means that the rental received is slightly lower than under an incentive-driven arrangement. 

An alternative may be to attempt to claw back only those incentives that are provided up front (here, the landlord tried to claw back a rent reduction and singage fee reduction as well as its predecessor's contribution to the fit out). However, even that may still be a 'penalty' if it is not a genuine attempt to assess the actual loss that the landlord may suffer in the future if the lease is breached. 

W G Stark 

Hayden Starke Chambers