Unreasonable Liquidated Damages = Impermissible Penalty

Unreasonable Liquidated Damages = Impermissible Penalty:
Sohal Properties, LLC v. MOA Properties, LLC

     On October 21, 2011, the Court of Appeals issued its opinion in Sohal Properties, LLC v. MOA Properties, LLC, No. 2010-CI-001833-MR (“To Be Published”), addressing the question of whether the $500,000 “non-refundable” deposit/liquidated damages provision would be enforceable under Kentucky law.  Finding the provision to be in the nature of an impermissible penalty, the provision was struck down.

     MOA Properties, LLC and Motels of America, LLC (their exact relationship is not fully detailed in the opinion) (“MOA”), leased to Sohal Properties the right to operate a Super 8 branded motel in Louisville.  The terms of the lease between MOA and Sohal Properties included the lockbox deposit of all receipts, disbursements from that lockbox to a master account from which withdrawals were made for the monthly rent, accrued property taxes, accruals for insurance and contributions to a capital reserve account.  The balance was, a monthly basis, returned to Sohal Properties.  The lease included as well a requirement that Sohal pay $500,000 (“security deposit”) at its commencement.  Absent default, at the end of the lease term, Sohal was entitled to a return of the funds accumulated in the capital reserve account.  The lease provided as well that Sohal Properties would have a right to acquire the property at the end of the lease term, the acquisition price being $2,700,000.  In the event that Sohal Properties exercised that option to purchase, the $500,000 security deposit, otherwise non-refundable, would be applied to the purchase price. 

      At the end of the lease, Sohal Properties sought to exercise the purchase option but, in the absence of adequate funding (this was early 2009, deep in the credit crunch) it was unable to perform.

      In response to an action filed by MOA seeking possession of the facility  and for various breaches of the lease and related agreements, Sohal Properties filed a counterclaim contending, in part, that the non-refundable nature of the security deposit violated public policy and should be unenforceable.  The trial court granted MOA summary judgment affording it both possession of the property and determination that the security deposit was its to be retained.  The Court of Appeals would reject that second condition. 

       With respect to the non-refundability of the $500,000 security deposit, the Court recited (slip op. at 10-12) the familiar Kentucky law on liquidated damages including Mattingly Bridge Co., Inc. v. Holloway & Son Constr. Co., 694 S.W.2d 702 (Ky. 1985) and United Services Auto Ass’n v. ADT Security Services, Inc., 241 S.W.3d 335 (Ky. App. 2006).  Applying that law, the Court determined that the security deposit of $500,000 was “grossly disproportionate” to any anticipated losses under the lease agreement, noting that there existed other contract terms that minimized the risk of loss.  Ultimately, the Court determined that the security deposit “must be construed as an impermissible penalty or forfeiture rather than as a valid liquidated damages clause.    Although the parties were properly at liberty to fashion a mutually beneficial business transaction, we conclude that it would be unconscionable to allow the forfeiture provided for in this agreement to be enforceable.”