By: Shantel M. Castro
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
Recently, in In re The Great Atlantic & Pacific Tea Company, Inc.,[i] the District Court for the Southern District of New York upheld a bankruptcy-court order enforcing an abatement provision in a lease.[ii] The case involved a twenty-year lease between a commercial landlord and a grocery store.[iii] Under the terms of the lease, the grocery store was to construct its own building on the leased premises, and the landlord would pay the grocery store a $1.9 million construction allowance within ninety days of the grocery store opening to the public.[iv] A provision in the lease stated that if the landlord failed to pay the construction allowance, the grocery store’s obligation to pay fixed rent and other charges would abate until the allowance was paid with interest.[v] The lease further provided that the grocery store would have title to the building until such time. [vi] A subsequent section of the lease entitled “Landlord default” detailed the remedies available to the grocery store in the event of a default by the landlord.[vii] After the grocery store opened, but just prior to the deadline for payment of the construction allowance, the grocery store filed for bankruptcy under chapter 11 of the Bankruptcy Code.[viii] The landlord’s financing for the construction allowance was conditioned on the grocery store assuming the lease.[ix] The lease was not assumed prior to the payment deadline for the construction allowance, therefore the landlord could not close on its financing.[x] Consequently, the landlord did not pay the construction allowance on time.[xi] Therefore, the grocery store withheld rent payments and property taxes due under the lease until the construction allowance was paid nine months later.[xii] The landlord commenced an adversary proceeding to collect the rent and filed a cure claim after the grocery store assumed the lease.[xiii] The bankruptcy court dismissed the adversary proceeding and denied the cure claim.[xiv] On appeal, the district court affirmed.[xv]
The Great Atlantic court’s decision is in line with current law on the enforceability of forfeiture provisions.[xvi] Under New York law, in order for a forfeiture clause to be enforced (1) the right to declare a forfeiture must be distinctly reserved; (2) the proof of the happening of the event in which the right is to be exercised must be clear; (3) the party entitled to do so must exercise the right promptly; and (4) the result of enforcing the forfeiture must not be unconscionable.[xvii] Absent fraud, accident, surprise, or improper practice, the court will enforce the provision if the parties contract for a forfeiture.[xviii] A court will enforce unambiguous terms even if the result is a windfall payment to one of the parties.[xix] In determining whether to enforce a forfeiture provision, the court often considers the character of the provision as either a penalty or liquidated damages.[xx] While a liquidated damages clause may be enforced if it is a good faith estimate of damages, parties may not fix a penalty for breach.[xxi] State law can deem such a contract unlawful.[xxii] In In re The Great Atlantic & Pacific Tea Company, Inc, the landlord argued that the lease term constituted an unenforceable penalty while the supermarket argued liquidated damages. The district court rejected both arguments, instead finding that the provision was a forfeiture. The court’s decision reinforced its strong policy in enforcing the unambiguous terms of a contract.[xxiii]
Courts may enforce forfeiture provisions, especially if under New Jersey law. Parties involved in commercial leases should be aware that forfeiture provisions will be interpreted by their plain meaning. A court will assume that sophisticated parties knew what they were doing and chose not to provide for a set-off as opposed to a complete forfeiture. Importantly, a court will not use its equitable powers to rewrite the contract for the benefit of one of the parties. In addition, since the withholding of rent will not be considered a breach of the lease, the landlord will not have a valid cure claim if the debtor seeks to assume the lease. As the Great Atlantic & Pacific Tea Company decision demonstrates, a forfeiture clause can provide a significant advantage for a chapter 11 debtor.[xxiv] If the debtor is able to abate its rent, then it has the potential of drastically reducing its operating costs, making it easier to reorganize its finances.
[i] In re The Great Atlantic & Pacific Tea Company, Inc.,510 B.R. 42 (S.D.N.Y. 2014).
[ii] See id. at 44 (reasoning no payments were due during period of breach).
[iii] See id. (detailing 20-year lease between landlord and grocery store with requirement of construction allowance).
[vi] Id at 45 (reviewing provision granting A&P title until construction allowance paid in full).
[vii] See id. (discussing proceedings below where NP argued subsequent section of lease modified construction allowance).
[viii] See id. at 45 (detailing timeline of events resulting in this action).
[x] See id.
[xi] See id.
[xii] See id.
[xiii] See id. (landlord argued that the specific mention of the construction allowance in the thirty-percent limitation clause implies that the other provisions in the landlord default section did apply. The court found the evidence did not support this position).
[xiv] See id. at 47 (landlord argued that the provision constituted an unenforceable penalty. Grocery Store argued that the provision was a liquidated damages clause. In the end the court rejected both claims, finding that the easiest way to evaluate the provision was as a forfeiture. The landlord was ordered to pay the complete construction allowance, plus interest).
[xv] In re The Great Atlantic & Pacific Tea Company, Inc.,510 B.R. at 54.
[xvi] Dunkin Donuts of America, Inc. v. Middletown Donut Corp., 495 A.2d 66 (Area YR) (reversing lower court and enforcing forfeiture of franchise upon default of terms in franchise agreement).
[xvii] 4-27 NY Practice Guide: Real Estate § 27.04.
[xviii] See In re Great Atlantic & Pacific Tea Co., Inc., 510 B.R. at 52 (applying standard set out in Dunkin Donuts of court not interfering absent fraud, accident, surprise, or improper practice).
[xix] See id. (enforcing forfeiture despite windfall to A&P since no fraud, accident, surprise, or improper practice).
[xxi] See Spialter v. Testa, 162 N.J. Super.421, 429 (Cty. Ct. 1978).
[xxiii] See In re Great Atlantic & Pacific Tea Co., Inc., 510 B.R. at 49.
[xxiv] An anchor tenant is most likely to have such a provision.