Wasserman's Inc. v. Township of Middletown

POLLOCK, J.

Pursuant to a public advertisement for bids, plaintiff Wasserman's Inc. (Wasserman's) and defendant, Township of Middletown (the Township or Middletown), entered into a commercial lease for a tract of municipally-owned property. The agreement contained a clause providing that if the Township canceled the lease, it would pay the lessee, Wasserman's, a pro-rata reimbursement for any improvement costs and damages of twenty-five percent of the lessee's average gross receipts for one year. In 1989, the Township canceled the lease and sold the property, but refused to pay the agreed damages. . . . We conclude that the lease is enforceable. We affirm the award of renovation costs and remand to the Law Division the issue of the enforceability of the stipulated damages clause.

-I-

The Township owned a parcel of approximately 20,500 square feet in a commercial area at 89 Leonardville Road, in the Belford section of the Township. From 1948 to 1968, Wasserman's leased the property from the Township for a 3,200-square-foot general store. In 1969, the Township advertised for bids to lease the property, which the Township evaluated at $ 47,500. Wasserman's submitted the sole bid. After rejecting Wasserman's bid, the Township again advertised in May 1970. Once again, Wasserman's submitted the only bid. Subsequent negotiations resulted in the Township adopting a resolution approving the lease on September 22, 1970. The parties signed the lease on May 21, 1971.

At the center of the dispute is the cancellation clause in the lease. The bid specifications provided that if the Township cancelled the lease, it would pay the tenant a pro-rata reimbursement of improvement costs. Consistent with the specifications, the clause provides in part for reimbursement: "payment to be made shall be (1.) total value of all improvements made by lessee at time of construction x (multiplied by) years remaining in Lease term / (divided by) total number of years in Lease term." More controversial is the second half of the clause, the terms of which were not included in the original specifications. That provision requires the Township to pay "(2.) twenty-five percent of the lessee[']s average gross receipts for one year (to be computed by + (adding) the lessee[']s total gross receipts for the lessee[']s three full fiscal years immediately preceding the time of cancellation of the lease and / (dividing by) 12 (twelve)[) ]." The lease also provided for a fixed monthly rental of $ 458.33, with no escalation for the entire thirty-year term.

Wasserman's made the agreed improvements, spending $ 142,-336.01 in 1971 on the expansion and renovation of the store, which now is approximately 5,600 square feet. In August 1973, Wasserman's sold "the business," presumably the corporate assets, and sublet the premises to Rocco Laurino doing business as Jo-Ro, Inc. (Jo-Ro). The sublease provided that Jo-Ro was to pay Wasserman's a monthly rent of $ 1,850. Wasserman's and Jo-Ro, jointly described as "plaintiffs," provided for an allocation of any payments made by the Township if it cancelled the lease.

In 1977, Samuel Krawet and Arnold Kornblum purchased from Laurino all of the Jo-Ro stock for $ 95,000. In connection with the sale, Laurino executed an affidavit, representing that the lease between Middletown and Wasserman's was in full force and effect. Additionally, the Township sent a letter to Wasserman's stating that the Township would permit subletting the property to Jo-Ro.

By letter dated December 7, 1987, the Township cancelled the lease effective December 31, 1988. Krawet and Kornblum vacated the premises, leaving them without a place for their business. In June 1989, the Township, after advertising the property at public auction, sold it for $ 610,000, nearly thirteen times the value of the property at the time the Township had leased it to Wasserman's in 1971. . .

-II-

. . . The Law Division initially granted plaintiffs a partial summary judgment according "full force and effect" to the lease and the cancellation clause. On a subsequent motion, the court awarded plaintiffs damages of $ 346,058.44 plus ten-percent prejudgment interest. The trial court calculated damages as follows:
$ 142,336.01 (construction costs) multiplied by 11.75 (remaining years) divided by 30 years (term of lease) for a total of $ 55,748.27.

$ 3,483,722.25 (Jo-Ro's gross receipts for the years 1985, 1986, 1987) divided by 12 equalling $ 290,310.18.
Construction compensation $ 55,748.27
Gross receipts compensation + 290,310.18

Total amount due $ 346,058.45

-III-

[In defense the township argued that the lease did not meet the requirements of a valid public contract. The court disagreed with this argument.]

-IV-

The provision in the termination clause providing for damages based on the lessee's gross receipts presents a more difficult issue. The issue is whether that provision is an enforceable liquidated damages provision or is an unenforceable penalty clause.

Disapproval of penalty clauses originated at early common law when debtors bound themselves through sealed penalty bonds for twice the amount of their actual debts . . . . Because clauses in penalty bonds "carried an unusual danger of oppression and extortion," equity courts refused to enforce them. . . "This equitable rule, designed to prevent over-reaching and to give relief from unconscionable bargains, was later adopted by courts of law." . . . In a sense, judicial reluctance to enforce penalty clauses is a product of history.

For more than five centuries, courts have scrutinized contractual provisions that specify damages payable in the event of breach . . . The validity of these "stipulated damage clauses" has depended on a judicial assessment of the clauses as an unenforceable penalty or as an enforceable provision for "liquidated damage." Thus, "'[l]iquidated damages' and 'penalties' are terms used to reflect legal conclusions as to the enforceability or nonenforceability, respectively, of stipulated damage clauses." . . .

Thirty years ago, the Appellate Division distinguished liquidated damages and penalty clauses:
Liquidated damages is the sum a party to a contract agrees to pay if he breaks some promise, and which, having been arrived at by a good faith effort to estimate in advance the actual damages that will probably ensue from the breach, is legally recoverable as agreed damages if the breach occurs. A penalty is the sum a party agrees to pay in the event of a breach, but which is fixed, not as a pre-estimate of probable actual damages, but as a punishment, the threat of which is designed to prevent the breach.

Parties to a contract may not fix a penalty for its breach. The settled rule in this State is that such a contract is unlawful. . .

Stating the distinction, however, has been easier than describing its underlying rationale. "'[T]he ablest judges have declared that they felt themselves embarrassed in ascertaining the principle on which the decisions [distinguishing penalties from liquidated damages] were founded.'" . . .

As the law has evolved, a stipulated damage clause "must constitute a reasonable forecast of the provable injury resulting from breach; otherwise, the clause will be unenforceable as a penalty and the non-breaching party will be limited to conventional damage measures." . . . So viewed, "reasonableness" emerges as the standard for deciding the validity of stipulated damages clauses. . . .

The reasonableness test has developed as a compromise between two competing viewpoints concerning stipulated damages clauses. The Wisconsin Supreme Court has described the policy considerations underlying these viewpoints:

Enforcement of stipulated damages clauses is urged because the clauses serve several purposes. The clauses allow the parties to control their exposure to risk by setting the payment for breach in advance. They avoid the uncertainty, delay, and expense of using the judicial process to determine actual damages. They allow the parties to fashion a remedy consistent with economic efficiency in a competitive market, and they enable the parties to correct what the parties perceive to be inadequate judicial remedies by agreeing upon a formula which may include damage elements too uncertain or remote to be recovered under rules of damages applied by the courts. In addition to these policies specifically relating to stipulated damages clauses, considerations of judicial economy and freedom of contract favor enforcement of stipulated damages clauses.

A competing set of policies disfavors stipulated damages clauses, and thus courts have not been willing to enforce stipulated damages clauses blindly without carefully scrutinizing them. Public law, not private law, ordinarily defines the remedies of the parties. Stipulated damages are an exception to this rule. Stipulated damages allow private parties to perform the judicial function of providing the remedy in breach of contract cases, namely, compensation of the nonbreaching party, and courts must ensure that the private remedy does not stray too far from the legal principle of allowing compensatory damages. Stipulated damages substantially in excess of injury may justify an inference of unfairness in bargaining or an objectionable in terrorem agreement to deter a party from breaching the contract, to secure performance, and to punish the breaching party if the deterrent is ineffective. . .

Consistent with the principle of reasonableness, New Jersey courts have viewed enforceability of stipulated damages clauses as depending on whether the set amount "is a reasonable forecast of just compensation for the harm that is caused by the breach" and whether that harm "is incapable or very difficult of accurate estimate.". . .

Uncertainty or difficulty in assessing damages is best viewed not as an independent test . . but rather as an element of assessing the reasonableness of a liquidated damages clause . . . Thus, "[t]he greater the difficulty of estimating or proving damages, the more likely the stipulated damages will appear reasonable.". . .

Some courts in other jurisdictions have also considered whether the parties intended the clause to be one for liquidated damages. . . Even those courts recognize that "subjective intent has little bearing on whether the clause is objectively reasonable." . . . For the past eighty years, New Jersey courts have relied on the "circumstances of the case and not on the words used by the parties" in determining the enforceability of stipulated damages clauses. . . We conclude that the parties' characterization of stipulated damages as "liquidated damages" or as a "penalty" should not be dispositive.

Although the Appellate Division has indicated that courts should determine the enforceability of a stipulated damages clause as of the time of the making of the contract . . . the modern trend is towards assessing reasonableness either at the time of contract formation or at the time of the breach. . .

Actual damages, moreover, reflect on the reasonableness of the parties' prediction of damages. "If the damages provided for in the contract are grossly disproportionate to the actual harm sustained, the courts usually conclude that the parties' original expectations were unreasonable." . . . Determining enforceability at the time either when the contract is made or when it is breached encourages more frequent enforcement of stipulated damages clauses. . . .

Two of the most authoritative statements concerning liquidated damages are contained in the Uniform Commercial Code and the Restatement (Second) of Contracts, both of which emphasize reasonableness as the touchstone. Farnsworth, supra, § 12.18 at 938. Thus, section 2-718 of the Uniform Commercial Code, adopted in New Jersey as N.J.S.A. 12A:2-718, provides:
(1) Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or non-feasibility of otherwise obtaining an adequate remedy.

Similarly, the Second Restatement (Second) of Contracts provides:

Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty. . .

Consistent with the trend toward enforcing stipulated damages clauses, the Appellate Division has recognized that such clauses should be deemed presumptively reasonable and that the party challenging such a clause should bear the burden of proving its unreasonableness. . . Similarly, most courts today place the burden on the party challenging a stipulated damages clause. . . . Thus, the party challenging a stipulated damages clause "must establish that its application amounts to a penalty." . . .

In commercial transactions between parties with comparable bargaining power, stipulated damage provisions can provide a useful and efficient remedy. . . . Sophisticated parties acting under the advice of counsel often negotiate stipulated damages clauses to avoid the cost and uncertainty of litigation. Such parties can be better situated than courts to provide a fair and efficient remedy. Absent concerns about unconscionability, courts frequently need ask no more than whether the clause is reasonable. We do not reach the issue of the enforceability of liquidated damage clauses in consumer contracts. Notwithstanding the presumptive reasonableness of stipulated damage clauses, we are sensitive to the possibility that, as their history discloses, such clauses may be unconscionable and unjust. . .

-V-

The purpose of a stipulated damages clause is not to compel the promisor to perform, but to compensate the promisee for non-performance. . . Accordingly, provisions for liquidated damages are enforceable only if "the amount so fixed is a reasonable forecast of just compensation for the harm that is caused by the breach." . . . One injured by a breach of contract is entitled only to just and adequate compensation. . . Thus, the subject cancellation clause is unreasonable if it does more than compensate plaintiffs for their approximate actual damages caused by the breach.

Whether measured from the time of execution of the contract or from the termination of the lease . . damages based on gross receipts run the risk of being found unreasonable. Generally speaking, gross receipts do not reflect actual losses incurred because of the cancellation. Gross receipts, unlike net profits, do not account for ordinary expenses; nor do they account for the expenses specifically attributable to the breach. Here, we cannot determine whether the stipulated amount was based on damages that would likely flow from a breach or whether it is an arbitrary figure unrelated to any such damages.

. . . Courts also have disapproved the use of gross receipts as a measure of damages apart from stipulated damages clauses. In a Colorado case involving a landlord's breach of a lease, the trial court allowed the jury to determine damages based only on the tenant's loss of gross profits. The Supreme Court of Colorado reversed, stating that "[g]ross profits do not furnish the proper basis for damages for loss of business. . . . Damages sustained by a business must relate to loss of net profits; they may not be speculative, remote, imaginary, or impossible of ascertainment.". . .

Evaluating damages based on gross income is problematic partly because such damages would be too speculative or uncertain. Assessing damages only from gross receipts has been described as an exercise in "pure guess and speculation." . . .

Furthermore, basing damages on gross profits could award the plaintiff a windfall. . . .
We cannot determine from plaintiffs' gross receipts the losses they sustained because of the Township's cancellation of the lease. The subject clause requires the Township to pay damages of twenty-five percent of the lessee's average gross receipts for one year. Under the lease, average gross receipts are calculated by taking an average of the lessee's total gross receipts for three fiscal years immediately preceding the cancellation. So calculated, Jo-Ro's average yearly gross was $ 1,161,240.75. Twenty-five percent of this figure amounts to $ 290,310.18.

This amount, however, does not necessarily reflect plaintiffs' actual losses on considering operating expenses or relocation costs and other expenses attributable to defendant's breach. As reflected in Jo-Ro's income-tax returns, Jo-Ro earned a net profit of $ 3,649 in 1985, $ 414 in 1986, and sustained a loss of $ 323 in 1987. We recognize the difference between tax losses and actual losses. Yet, to the extent that tax returns reflect actual profit or loss, they demonstrate the unreasonableness of damages exceeding $ 290,000, which were calculated on the basis of gross receipts.

The decision whether a stipulated damages clause is enforceable is a question of law for the court . . . Although the question is one of law, it may require resolution of underlying factual issues. . .

On balance, we believe we should remand this matter to the trial court to consider the reasonableness of the clause in light of this opinion. In resolving that issue, the court should consider, among other relevant considerations, the reasonableness of the use of gross receipts as the measure of damages no matter when the cancellation occurs; the significance of the award of damages based on twenty-five percent of one year's average gross receipts, rather than on some other basis such as total gross receipts computed for each year remaining under the lease; the reasoning of the parties that supported the calculation of the stipulated damages; the lessee's duty to mitigate damages; and the fair market rent and availability of replacement space. We leave to the sound discretion of the trial court the extent to which additional proof is necessary on the reasonableness of the clause. Because stipulated damages clauses are presumptively reasonable . . . the burden of production and of persuasion rests on the Township.

To summarize, we affirm the judgment of the Appellate Division that the Township is liable to plaintiffs for terminating the lease. . . We also affirm the judgment of the Appellate Division awarding plaintiffs damages of $ 55,748.27 for renovation costs. We remand to the Law Division the issue whether the clause requiring payment of stipulated damages based on the lessee's gross receipts is a valid liquidated damages clause.

The judgment of the Appellate Division is affirmed in part, reversed in part, and the matter is remanded to the Law Division.