Staying Out Of The Penalty Box: New Appellate Court Decision Provides Intriguing New Angle On What Constitutes An Unenforceable Penalty

The Second Appellate District of the California Court of Appeal recently issued a decision in Constellation-F, LLC v. World Trading 23, Inc. finding that a holdover provision in a commercial lease providing for significantly increased rents during the holdover period is not an unenforceable penalty under California Civil Code section 1671.  While this decision directly implicates holdover provisions in commercial leases, its broad language focusing on the contracting parties' respective bargaining powers may implicate other contractual relationships.

Unenforceable Penalties In California

California law, as codified in Civil Code Section 1671, generally provides that contractual liquidated damages provisions are unenforceable if the terms do not reflect a reasonable estimate of potential future damages under the circumstances which existed at the time the contract was formed. In most cases, the party challenging the contractual provision bears the burden of proving the provision is unreasonable.

This law is most commonly invoked by borrowers challenging the imposition of prepayment penalties, late charges, or default interest by their lenders, but has also been raised in other contexts with mixed results. The Second District, however, has now taken a novel approach that dispenses with the standard analysis under Section 1671 and instead focuses on the relative bargaining power of the parties.

Holdover Rents Are Not Liquidated Damages And Are Not Barred By Civil Code Section 1671

In Constellation-F, the parties disputed the enforceability of a holdover rent provision providing for an increase in base rent by 150% in the event tenant failed to vacate the premises following lease termination. Tenant successfully challenged the provision at trial, arguing it was an unenforceable penalty barred by Civil Code Section 1671.

On appeal, the majority of the court reversed the trial court's decision, finding that the holdover rent provision was enforceable. In so holding, the court cited Vucinich v. Gordon (a 1942 appellate decision) for its finding that holdover rents, or "graduated rents," are not "damages" governed by Section 1671 but simply reflect additional rents negotiated by parties in arms-length dealings. The court further explained that the policy underlying Section 1671 limits its application to combating "unfair and unreasonable coercion arising from an imbalance of bargaining power." The tenant's burden, according to the court, was to prove that the landlord had "market power," which the majority broadly analogized to the power exerted by monopolists oppressing consumers, and that tenant therefore had no competitive alternative to signing the lease at issue. Based on the absence of any evidence that the landlord had such monopolistic power, the majority determined that Section 1671 did not apply and the holdover rent provision was therefore valid and enforceable.

Notably, the dissenting opinion in Constellation-F strongly objected to the majority's holding on the issue, citing long-recognized California Supreme Court decisions in Ridgley v. Topa Thrift & Loan Assn. and Garrett v. Coast & Southern Fed. Sav. & Loan Assn.  These cases, which the majority distinguished on the grounds that they did not involve holdover rent provisions, involved challenges to late payment and default interest provisions in loans and established the generally accepted test to determine enforceability under Section 1671 - whether the charges imposed bear any rational relation to anticipated harm. The dissent in Constellation-F heavily criticized the majority's decision as a departure from established California law, perhaps foreshadowing a petition for review to the California Supreme Court.

Broader Implications Of Constellation-F

Constellation-F clearly sets a new guidepost when it comes to the enforceability of holdover rent provisions in commercial leases. However, it is important to note that Constellation-F was decided in the context of an action for damages for breach of lease, not an action for unlawful detainer. Thus, the court did not decide whether the holdover rent would qualify as "rent" for purposes of a 3-day notice to pay rent or quit under Code of Civil Procedure (CCP) § 1161(1) or whether it would require a separate notice for breach of covenant (CCP § 1161(3)), nor did the court address case law limiting the "actual damages" a landlord may recover under CCP § 1174(b) for wrongful holdover in an eviction action to the reasonable rental value of the premises. How courts apply Constellation-F in unlawful detainer actions remains to be seen.

It also remains unclear how the decision may be applied in other settings, assuming it avoids or survives further appeal, and how it may affect parties' contracting strategy in the future. Will lenders rephrase default interest provisions to avoid any implication that they relate to damages? Will parties start including representations concerning equal bargaining power or the existence of competitive alternatives? If Constellation-F remains good law, parties seeking to impose these kinds of post-default provisions will certainly adjust their contracts accordingly.

Stay tuned to see whether Constellation-F represents a fundamental shift in how California courts apply, or decide not to apply, Civil Code Section 1671 to post-default charges in contracts.