Supreme Court rules on penalty clauses in lease agreements

Facts
Lower court decisions
Supreme Court decision

The Supreme Court recently analysed the differences between compensatory and punitive penalty clauses in lease agreements and established the requirements for the latter to be valid.(1) The court also ruled that a punitive penalty clause's amount cannot be reduced simply because the lessor enters into a new lease agreement immediately after recovering possession of the commercial premises.

Facts

The Supreme Court's decision concerned a 10-year commercial premises lease agreement which two companies had entered into in June 2005.

The contract established that if the lessee unjustifiably terminated the contract prematurely, it would have to pay the lessor according to the penalty clause included therein, which called for payment of:

An amount equivalent to twenty five per cent (25%) of the outstanding rent amounts prior to June 1, 2010 and forty per cent (40%) of the outstanding rent amounts from such date until the contract's termination, all of the foregoing without prejudice to the Lessor's entitlement to claim the outstanding rent and compensation for the damages that such an early termination may have caused it.

As a result of the lessee's non-payment of the rent, the lessor filed an eviction suit and, after following the appropriate procedure, recovered possession of the commercial premises on 8 October 2012. Immediately thereafter, the lessor:

• leased the commercial premises to a third party; and
• filed a lawsuit against the lessee claiming:
  • the application of the penalty clause; and
  • payment equal to 40% of the rent corresponding to the period from 8 October 2012 to the contract's agreed termination date (30 June 2015).

Lower court decisions

The Cuenca First-Instance Court Number 1 dismissed the suit on the grounds that the application of a penalty clause should be limited to the time during which the commercial premises remain unleased, a situation which did not occur in the case in question.

The Cuenca Appellate Court subsequently confirmed the first-instance decision and added that:

• the penalty clause should be considered unlawful because its purpose had been punitive; and
• the purpose of a penalty clause, pursuant to Article 1152 of the Civil Code, is to replace the compensation for damages that a lessee's breach causes the lessor. Thus, if such damages have not occurred, the penalty clause cannot be applied.

Supreme Court decision

The Supreme Court's decision divided the analysis of the cassation appeal filed by the lessor in two.

Regulatory and case law framework
To decide the issue in question, the Supreme Court first established the regulatory and case law framework in which the matter had to be resolved. Specifically, it outlined the following:

• Penalty clauses with a coercive, penalising or punitive purpose are valid under Spanish law, except when included in:
  • consumer contracts; or
  • contracts between businesspersons where an abuse of power occurs.

• Penalty clauses with a punitive function do not entail an early liquidation of the damages and thus can be applied cumulatively to the compensation of damages.
• The Supreme Court held that a punitive penalty clause must aim to dissuade a lessee from terminating the contract prematurely. Thus, a punitive penalty clause must not have a preventive aim, which would have occurred in this case if the lessee had been required to pay the entire rent amount until the original contract termination date. In this regard, the Supreme Court referred to its decision of 29 May 2014 (300/2014) in which it had reduced a punitive penalty clause that obliged the lessee to pay all of the rent corresponding to the remaining contractual period in the event that the contract was terminated early. The Supreme Court justified the clause's moderation by stating that the purpose of the agreed clause had been preventive rather than dissuasive.
• Penalty clauses with a punitive or compensatory function must take effect when a secured obligation is breached (Article 1152 of the Civil Code). The courts may reduce the penalty clause's amount only if the obligation has been partially breached (Article 1154 of the Civil Code). However, a penalty clause's amount cannot be reduced when it is established specifically for a situation where a partial breach occurs.
• The Supreme Court highlighted that a significant part of the academic doctrine supports modifying the Spanish legal system with the aim of authorising courts to reduce penalties which have:
  • a punitive function and are manifestly excessive; or
  • a compensatory function and are disproportionate to the damage that has actually been caused.

The Supreme Court also highlighted that there have been several legislative initiatives in this area. However, the Supreme Court insisted that it must respect its case law as indicated in the above bullet until Article 1154 of the Civil Code is modified.

Resolution of disputed issue
The Supreme Court upheld the cassation appeal and ordered the lessee to pay the amount established in the penalty clause in its entirety. The court based this decision on the following arguments:

• The penalty clause was valid, as the contract had been entered into between two businesspersons and the lessor had not been in an abuse of power situation.
• The penalty clause did not require the rent to be paid for all of the years for which the contract remained to be complied with. Instead, it consisted of tiered percentages, which served as a dissuasive instrument, but did not prevent early termination.
• The penalty clause was punitive rather than compensatory. Thus, the penalty clause had been enforceable once the stipulated breach had occurred, regardless of whether the lessor had suffered damages.

Conclusion
The Supreme Court concluded that the disputed penalty clause:

• was punitive and not compensatory;
• had aimed to dissuade the lessee from terminating the contract early, but did not prevent such termination;
• was valid in accordance with the Spanish legal system; and
• did not entail a liquidation of the damages.

Consequently, the Supreme Court concluded that the fact that the lessor had entered into a new lease agreement immediately after recovering possession of the commercial premises and thus had not suffered any damage due to the early termination of the contract was not a circumstance which would permit a reduction of the punitive penalty clause. Thus, the Supreme Court ordered that the punitive penalty clause be applied in its entirety.

For further information on this topic please contact Ana Ribó or Leah Daniels at Pérez-Llorca by telephone (+34 93 481 30 75) or email (aribo@perezllorca.com or ldaniels@perezllorca.com). The Pérez-Llorca website can be accessed at www.perezllorca.com.

Endnotes

(1) Supreme Court Decision 74/2018 of 14 February 2018.