Liquidated Damages Clause Runs Dry for Residential Landlord

August 2018

In August 2018, the Appellate Division of the Superior Court of California, County of Humboldt, reversed a lower court decision and ruled that a late fee in a residential lease for failure to pay rent was prohibited by California Civil Code Section 1671.  In Del Monte Properties and Investments, Inc. v. Dolan (Cal. App. Dep’t Super. Ct., May 11, 2018, No. CV170392), the landlord leased residential premises to the tenant at a monthly rent of $600.  When the tenant failed to pay rent on time, the landlord served the tenant with a 3-day notice to either pay rent or vacate the premises.  The 3-day notice demanded rent in the amount of $600, as well as a late fee in the amount of $50 (approximately 8.33% of the monthly rent).  The late fee was set forth in the lease by a commonly used liquidated damages provision as follows:

“Tenant acknowledges either late payment of Rent or issuance of a returned check may cause Landlord to incur costs and expenses, the exact amount of which are extremely difficult and impractical to determine.  These costs may include, but are not limited to, processing, enforcement and accounting expenses, and late charges imposed on Landlord.  If any installment of Rent due from Tenant is not received by Landlord within 5 calendar days after the date due, or if a check is returned, Tenant shall pay to Landlord, respectively, an additional sum of $50.00 as a Late Charge and $25.00 as a NSF fee for the first returned check and $35.00 as a NSF fee for each additional returned check, either or both of which shall be deemed additional Rent.

Landlord and Tenant agree that these charges represent a fair and reasonable estimate of the costs Landlord may incur by reason of Tenant’s late or NSF payment. Any Late Charge or NSF fee due shall be paid with the current installment of Rent…”

The trial court found for the landlord, ordering that the lease be forfeited and the premises returned to the landlord, as well as awarding the landlord past-due rent of $650 and holdover damages of $140.  The Appellate Division, however, reversed the trial court’s ruling based on two separate reasons: (1) the late fee cannot be justified as liquidated damages under California Civil Code Section 1671 because the losses caused by the late payment of rent were not extremely difficult or impractical to determine, and (2) the landlord failed to show that the liquidated damages charged were the result of a reasonable endeavor to approximate those losses.

California Civil Code Section 1671 treats liquidated damages differently between residential and commercial leases.  In a commercial lease, Section 1671(b) applies – it provides that “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made” (emphasis added).  Meanwhile, Section 1671(d) applies a different standard to residential leases and states that “a provision in a contract liquidating damages for the breach of the contract is void except that the parties to such a contract may agree therein upon an amount which shall be presumed to be the amount of damage sustained by a breach thereof, when, from the nature of the case, it would be impracticable or extremely difficult to fix the actual damage” (emphasis added).  Therefore, it can be said that there is a presumption of validity for a liquidated damages clause in a commercial lease, but a presumption of invalidity in a residential lease.  More importantly, to be valid, it is enough that a liquidated damages provision in a commercial lease is reasonable at the time of the contract – but in a residential lease, it must also be shown that the actual damages were impracticable or extremely difficult to fix.

In this case, the Appellate Division held that the landlord failed to articulate specific facts showing why the circumstances of the case justified liquidated damages to compensate losses caused by a late rent payment.  The court rejected the landlord’s testimony about the types of losses that the landlord anticipated suffering such as those contained in the lease provision (e.g., processing, enforcement and accounting expenses, and late charges imposed on Landlord) as  mere reference to the lease language.

Separately, the Appellate Division relied on case law to conclude that the liquidated damages clause must also be the result of the landlord’s reasonable endeavor to estimate the actual losses caused by the breach; merely setting the liquidated damages to a percentage of the contract price (as the landlord here admitted it did) is not sufficient.  Instead, there must be some analysis of actual losses prior to setting the damage amount.

Although pertaining to residential leases, Del Monte Properties should serve to put all landlords on notice that a liquidated damage clause in a lease may not be upheld if the landlord is unable to show that some prior analysis was done to try to estimate the amount of loss.  Most, if not all, commercial leases contain language similar to that contained in the Del Monte Properties residential lease, with late fees ranging from 2% to 10% of the monthly rent (most commonly set at 5%).  This holding will likely come as a surprise to many residential (and non-residential) landlords who have come to rely on these late fee provisions for decades, if not longer.  Accordingly, this case raises many new questions for landlords: Do landlords now have to start creating paper trails showing that they tried to estimate their damages on a lease by lease basis?  Will each transaction lead to a different liquidated damages amount?  How do you compare a lease with rents of $1,000 per month to a lease with rents of $100,000 per month, where each lease contains a 5% late fee?  Time will tell if this case is upheld or applied to a commercial lease context.  Until then, landlords should proceed cautiously.