Liquidated Damages for Lease Breaches

I am a commercial landlord. A tenant breached a lease and voluntarily vacated the property prior to its expiration. I re-rented the premises at a higher rate than was charged to the first tenant. The first lease provided that upon an early vacation by the tenants, I am able to retain all of the security deposit. Under these circumstances, am I able to keep any of the security deposit?

Generally, the answer to this question depends upon whether: (1) you have suffered damages in spite of the higher rental rate for the replacement tenant; and (2) the lease contains an enforceable liquidated damages provision.

Though the replacement tenant may be scheduled to pay more rent, the additional rent may not offset damages caused by the first tenant’s breach. For example, before vacating the premises, the defaulting tenant may have been $10,000 behind in rent. He may have damaged the premises requiring repairs of $15,000. You may have incurred $5,000 of commission obligations finding the replacement tenant. The replacement tenant might only be paying $500 a month more in rent over a two-year period.

Cases such as La Casa Nino, Inc. v. Plaza Esteban, 762 P.2d 669 (Colo. 1988) establish that the landlord must offset the incremental benefit of the replacement lease against the damages caused by the breaching tenant. (This case does not discuss whether the incremental benefit of the stream of future payments from the replacement lease should be discounted to present value or whether the payments should be discounted because of the possibility that they might not be paid.) In the preceding example, the landlord’s damages of $30,000 are not fully offset by the benefit to the landlord of the early termination ($12,000) so that the landlord has suffered $18,000 of actual damages. Under this scenario, the landlord may retain up to $18,000 of the breaching tenant’s security deposit.

However, in other circumstances, the landlord may incur less identifiable damages, if any. For example, the landlord may already have a replacement tenant so that there is no “down time” between the vacating and replacement tenants. Because the replacement tenant was “waiting in the wings,” the transfer may cause no marketing or commission expenses.

In many of these “orderly” transfers, the lease will contain a provision that if the tenant vacates the premises prior to the completion of its term, the tenant forfeits the earnest money. Are these clauses enforceable when the landlord suffers no easily identifiable damages as a result of the tenant’s breach.

In spite of a provision in the lease allowing the landlord to retain the security deposit because of the tenant’s early vacation of the leased premises, the Colorado Court of Appeals in Kirkland v. Allen, 678 P.2d 568 (Colo. App. 1984) refused to allow the landlord to keep any portion of the earnest money. Not only did the court prevent the landlord from retaining any portion of its security deposit, but it assessed treble damages against the landlord for doing so. (Kirkland involved a residential lease.) This was in spite of the fact that the landlord had timely sent out a notice to the tenant explaining why it was holding the security deposit. A landlord attempting to retain any portion of a security deposit pursuant to a liquidated damages clause in the lease, simply because of an early departure by the tenant, must overcome the Kirkland case. Fortunately, there are at least four possibilities for doing so.

First, the language in Kirkland ostensibly invalidating liquidated damages clauses in leases was not necessary to resolve the case and therefore has questionable significance.

Second, Kirkland involved a residential lease with particularly egregious facts. (The property was not only plagued with plumbing and structural problems, but was infested with rodents. The tenants occasionally awoke in the morning discovering varmint bites on their arms and legs.) The court may be more willing to enforce liquidated damages clauses for the benefit of reasonable commercial landlords against commercial tenants.

Third, though a landlord may have no easily identifiable damages from a tenant’s “orderly breach,” the landlord may still be hurt by early vacation. For example, a replacement tenant may have been content to accept other space in the building. The placing of the replacement tenant into the vacated premises may remove a viable tenant from the landlord’s waiting list, causing the landlord to incur commission or other marketing expenses for other space coming available in the future. The vacating tenant might be an “anchor” attracting customers for other tenants and increasing the rents for the entire property. The replacement tenant may be less of an anchor tenant. By aggressively marshalling these types of facts, the commercial landlord may be able to avoid the Kirkland result.

Fourth, a well drafted liquidated damages provision may avoid enforcement problems. The Colorado courts look to three factors in determining whether a clause purporting to liquidate damages in advance is enforceable: (1) the anticipated damages must be “uncertain in amount or difficult to be proved;” (2) the parties must have intended to liquidate the damages in advance; and (3) the amount of damages stated must be reasonable, not greatly disproportionate to the presumed loss or injury. A well drafted liquidated damages provision in a lease could identify why the damages from an early vacation are uncertain in amount or difficult to prove. (See examples in preceding paragraph.) The text could make it clear that the parties are intending to determine in advance the damages caused simply by virtue of the tenant’s early departure. To enhance the likelihood that the amount forfeited by the tenant would be found to be “reasonable,” the language could specify an amount less than the security deposit and perhaps provide for a decreasing amount as time passed. (For example, if the tenant vacates in the first year of the lease, $10,000 of the deposit would be forfeited simply because of the early vacation, $9,000 would be lost for an early vacation in the second year, … etc.

Using the four suggestions above, you may be able to avoid the Kirkland result.

A version of this article appeared in the Colorado REALTOR® News, the monthly publication of the Colorado Association of REALTORS®.

Jon Goodman is a shareholder with Frascona, Joiner, Goodman and Greenstein, P.C., a Colorado law firm. His practice areas include Real Estate,Brokerage Law, Contracts, Land Use, Leasing, Real Estate Title, Association Law, Business Law, and Finance. Contact Jon Goodman.

Disclaimer — Content is general information only. Information is not provided as advice for a specific matter, nor does its publication create an attorney-client relationship. Laws vary from one state to another. For legal advice on a specific matter, consult an attorney.

JONATHAN A. GOODMAN