If a lessee is in the wrong and has breached the lease resulting in a premature lease termination, you would expect the lessor would be able to claw back its lease incentives without any issue. Find out here why this is not necessarily the case…

This article by Deren Hassan, Partner, Litigation & Property Disputes, Mills Oakley is published in the latest issue of SCN Magazine.

Reflecting the prevailing market conditions, lease incentives have long been a staple feature of retail and commercial leasing in Australia. Lease incentives can take many different forms, including fit-out contributions, rent-free periods and rent abatements. In a post-pandemic era, the ‘new normal’ of increased e-commerce and participation in remote working arrangements has impacted effective rents and raised the importance of lessors providing lease incentives to drive demand for bricks-and-mortar retail and a return to the workplace.

Lease incentives are typically documented on terms that allow lessors to claw back the incentive (or a portion of it) if specified events occur, such as termination of the lease. The entitlement to claw back the incentive is premised on the lessor’s expectation that the lease will continue for the entire term and that if the lease is cut short, the lessor ought to be able to recover part of the incentive that has been invested proportionately to the balance of the lease term.

If the trigger for the claw back is a termination of the lease arising from default, the claw back terms in effect provide a formula for calculating the quantum of damages that is recoverable (ie. the proportion of the incentive). However, to be enforceable, the amount sought to be clawed back needs to reflect a genuine pre-estimate of the lessor’s damages. Otherwise, the repayments are at risk of being rendered a penalty and are not recoverable(i).

In the recent case of Alamdo Holdings Pty Ltd v Croc’s Franchising Pty Ltd (No 2)(ii), the right to claw back a fit-out contribution was held to be void as a penalty because it failed to reflect a genuine pre-estimate of the lessor’s damage and did not serve a legitimate purpose in guarding the lessor’s interests.

Facts
Alamdo Holdings Pty Ltd (Alamdo), the owner of Unit 5, 2 Hudson Avenue Castle Hill, New South Wales (the Premises), leased the Premises to Croc’s Franchising Pty Ltd (Croc’s), a franchisor of various playcentres throughout Australia. As part of a suite of documents including the lease, the parties entered into an Incentive Deed pursuant to which Alamdo agreed to pay $250,000 as a fit-out contribution.

In breach of the lease, Croc’s failed to pay rent and other lease charges for a six-month period, resulting in Alamdo terminating the lease. Alamdo then sought to claw back a proportion of the fit-out contribution calculated on a pro rata basis by reference to the balance of the initial term of the lease.

Contention
Alamdo accepted the principle that incentive repayment terms are a penalty if they can be characterised as a threat against Croc’s failing to comply with its lease obligations or as a punishment for permitting that circumstance to arise. However, Alamdo gave evidence suggesting that the formula for calculation of its loss was a genuine pre-estimate of its damages. The Incentive Deed and the lease allowed for a pro rata amount of the lease incentive to be repaid proportionate to the balance of the lease term.

The decision
The claw back provisions in the Incentive Deed were found to be a penalty.

Alamdo’s director, Mr Maurici, gave evidence(iii) indicating that the benefit given to Croc’s by the fit-out contribution was a commercial risk in the event the lease did not run its full course, albeit a risk that reflected the prevailing market conditions necessary to secure the lease deal. Maurici said that he was “conscious that Alamdo was exposed to a commercial risk if it paid the lease incentives but the Lease did not continue for the entire initial ten-year term. If the lease ended in less than ten years,” Maurici said that he “expected that Alamdo would need to pay a new lease incentive to secure a new tenant, and to locate and provide funding for that incentive, in order to secure a new tenant of the premises”.

It was significant that Alamdo was only able to procure the lease that it did, in the market conditions at the time, by making a substantial financial concession in the form of a fit-out contribution. In doing so, Alamdo had assessed the effective rent that it would be receiving, taking the incentive into account.

Alamdo was able to recover rental arrears and loss of bargain damages including loss of rent for any delay in finding a replacement tenant. Further, the lease allowed Alamdo to retain ownership of the fit-out. If Alamdo were also permitted to claw back a proportion of the fit-out contribution (in addition to retaining ownership of the fit-out), it would have been placed in a more favourable position than it would have been in had the lease run its full course absent any breach. The outcome would be to obtain a higher effective rent than otherwise allowed by the market conditions that prevailed at the time the lease was agreed to. Accordingly, it was held the claw back provisions went further than was necessary to protect Alamdo’s legitimate interests and should be characterised as a punishment for Croc’s breach of the lease.

Conclusion
Considering the substantial financial concessions that may be made, lessors will understandably continue to look for ways to claw back incentives on legally enforceable terms. The more creative options drafted to neutralise penal repayment conditions may include secured financing arrangements with expansive enforcement provisions if there is a lease default, rent abatements applied across the entire lease term and put option arrangements where the fit-out is assigned to the lessor with the option to sell on specified exercise dates throughout the lease term. Whether these and other avenues will be enforceable is yet to be tested. Any ancillary arrangement will be construed with all other documents entered into at the same time which are seen as arising out of the one transaction as a whole.(v)

Lessors may alternatively decide that instead of entering into complex arrangements designed to circumvent the penal effect of claw back terms that ultimately may be held to be void, a better solution may be simply to rely upon a claim for contractual damages, which would usually be expressly reserved in the lease.

This approach is reinforced by Dalton J in GWC Property Group Pty Ltd v Higginson(vi) who said there is: “… no reason to doubt that common law damages would not be an adequate remedy. In this case the failure of the primary stipulation was brought about by, indeed was, a breach of contract. This was a commercial leasing transaction. The repayment clauses were wholly penal in their operation: providing for significant sums to be paid over and above damages which would be payable to the landlord at common law”.

It appears inevitable that the approach to be taken by lessors when clawing back their incentives will be the subject of continued judicial consideration.

(i) I’d like to acknowledge Diahna Angelis, Paralegal, Mills Oakley for assisting me in writing this article.

(ii) [2023] NSWSC 60.

(iii) see paragraph 290

(iv) Suggested by Steven Cominos, Barrister, Six St James Hall Chambers.

(v) Fletcher Moulton LJ, Manks v Whiteley [1912] 1 Ch 735, 75