This issue has come before the courts in Australia a number of times over the last 10 years. The Supreme Court of Queensland has once again held an obligation to repay a lease incentive to be a penalty.
BMG SP Pty Ltd (BMG) as tenant, entered into a lease (Lease) with Swordfish Australia Sub TC Pty Ltd (Swordfish) as landlord in respect of premises at the Strathpine Centre, with the intention of operating a mini-golf business.
The Lease stipulated that, before BMG commenced trading:
BMG and Swordfish also concurrently entered into an incentive deed (Incentive Deed), under which Swordfish agreed to provide BMG with certain incentives including a fitout contribution of $1,250,000, which was to be paid in four instalments (Fitout Contribution).
Due to various delays in the completion of the Landlord Works and the Tenant Fitout Works, BMG was unable to commence trading on the agreed commencement date.
The Strathpine Centre was purchased by YFG Strathton Pty Ltd (YFG). Swordfish assigned its interest in both the Lease and the Incentive Deed to YFG as the new landlord.
At this stage, Swordfish had already paid BMG three instalments of the Fitout Contribution (totalling $1,000,000). The final instalment was due to be paid 30 days after BMG opened for trade.
The relationship between BMG and YFG deteriorated. BMG refused to progress the Tenant Fitout Works until YFG agreed to vary the commencement date to a later date and make other concessions.
YFG refused to agree to BMG’s demands without an assurance and evidence that the Tenant Fitout Works would be completed in a suitable timeframe. BMG refused to provide such assurance and evidence until its demands were met.
YFG contended that BMG had repudiated the contract and gave BMG notice that the Lease was terminated.
YFG also demanded that BMG pay $993,607.29, being a proportion of the Fitout Contribution, calculated by reference to clawback provisions set out in the Incentive Deed and the Lease (Repayment Clauses). The Repayment Clauses provided that, if the Lease was terminated due a default by BMG, then BMG was required to repay to FYG an amount calculated by reference to the amount of the Fitout Contribution provided to BMG.
BMG denied that it repudiated the Lease and refused to repay the amount demanded by YFG. BMG sought a declaration from the court that the Repayment Clauses were unenforceable as a penalty (as well as a declaration that YFG’s purported termination of the Lease was invalid and of no effect).
BMG submitted that:
YFG submitted that:
The Court held that the Repayment Clauses were unenforceable as a penalty and that the case was materially indistinguishable from GWC.
Penal in nature
In order to determine whether a provision is penal in nature, the terms and inherent circumstances of the provision must be scrutinised.
A penalty is in the nature of a punishment for non-observance of a contractual stipulation, and it imposes an additional or different liability upon breach of the contractual stipulation.
A distinction must also be drawn between a penalty and a pre-estimate of liquidated damages. A penalty is a payment of money that is in the nature of a threat or intimidation by the offending party, whereas liquidated damages are a genuine covenanted pre-estimate of damage.
The Court held that:
Extravagant or out of all proportion
To properly characterise the Repayment Clauses as penalties, consideration also had to be given to whether the Repayment Clauses provided for a payment that was extravagant or out of all proportion to YFG’s legitimate interests.
YFG’s interest was in the commercial leasing of its premises. Upon termination of the Lease due to BMG’s default, YFG would lose the benefit of the Lease and it would be entitled to recover damages for that loss. However, if enforced, the Repayment Clauses would allow YFG to receive additional advantages that it would not have otherwise received. The formula contained in the Repayment Clauses provided for a pro-rata recovery of the Fitout Contribution paid, which reduced over the lifetime of the Lease.
Accordingly, the Repayment Clauses could not be a genuine pre-estimate of loss. The only possible loss that related to the Repayment Clauses was the loss of the amount paid by YFG for the Fitout Contribution.
Ultimately, the Court held that the Repayment Clauses:
Landlords commonly provide incentives to tenants to enter into leases.
Provisions that simply require a tenant to repay a portion of the incentive are not enforceable.
That is not to say that an incentive is not recoverable from a tenant consequent upon a tenant’s breach under a lease. However, the mechanisms to achieve that result will be much more complicated than a simple repayment of a portion of the incentive.
* Acknowledgement: Sara Stikic, a lawyer in our Property and Leasing team, made a significant contribution in the preparation of this article.