In a recent ruling by the Bulgarian Supreme Court, which addressed the issue of penalty clauses in lease agreements, the high court ruled that assessments on the validity of penalty clauses should be made on a case-by-case basis.
At the same time, the court declared that the specific penalty clause cited in the case in question to be null and void, and justified this judgement by stating that the landlord had benefitted from the terminated lease relationship without providing the property to the tenant. As this went beyond the immanent functions of a penalty, the penalty provision under consideration contradicted good morals and was deemed null.
Background: landlords and liquidated damages
In Bulgaria, landlords tend to include penalty (i.e. liquidated damages) clauses in lease agreements that apply if a lease is prematurely terminated due to tenant default or at the tenant’s discretion. Such clauses state that the tenant must pay the landlord a penalty equal to the amount of rent due for the period starting from the termination date of the lease until the last day of the lease's scheduled term.
In 2016, the Bulgarian Supreme Court of Cassation affirmed the legality of such penalty clauses.
Ruling on a 2016 appeal of a decision of the Sofia Appellate Court, the Supreme Court responded to the following question: “Can the landlord claim from the tenant a penalty in the amount of all of the remaining rent payments, after the lease agreement has been terminated and the tenant no longer occupies the leased premises, when the parties have explicitly agreed on such penalties if the agreement is terminated by the tenant before the expiry of the initially scheduled term?”
In its decision, the court sustained the position that there should be a correlation between expected damages in a case of premature termination of the lease and the penalty amount. It further ruled, however, that these penalty clauses often go beyond the immanent functions of a penalty, which is to secure performance, indemnify the non-defaulting party and penalise the defaulting one.
If enforced, such penalties can result in the landlord’s receiving unmerited gain (e.g. the landlord could lease the premises to a new tenant and receive rents from both the defaulted tenant under the terminated lease and from the new tenant.)
Because the receipt of unmerited gains contradicts good morals, the Supreme Court judged in this case that the penalty clause should be considered null and void. While this decision was issued in the context of a penalty payable by a tenant when exercising a break option, the court’s ruling would also be applicable if a landlord terminated a lease because of tenant default, as this is conclusively ruled out in respect to financial lease agreements.
A Varna ruling tests this decision
During the last two years, attempts were made in the lower courts to justify the validity of such clauses. Each case proved unsuccessful, which posed the questions: Had the case law changed and is it possible to enforce such clauses?
Recently, when the matter was brought again to the Supreme Court of Cassation the tenant in the case asked almost the same question. In a decision on a lease dispute, the Varna Appellate Court ruled that a penalty clause providing payment by the landlord was valid. (Specifically, the agreement the court upheld guaranteed payment in the amount of “the monthly rent until the expiration of the term under the lease agreement, but no less than the rent payment for one year” for pre-mature termination due to landlord default.)
According to the court, this penalty clause had not gone beyond its immanent function since it was crucial for the parties to ensure that the lease is valid for its initially agreed term. In the court’s view, when the parties negotiated the penalty clause they took into consideration the expected economic benefits and damages to both parties.
This decision was reviewed by the Supreme Court of Cassation, which revoked it. The Supreme Court of Cassation did not conclusively answer the specific morality question: “Is the penalty for preliminary termination negotiated in favour of the tenant in the amount of the monthly rent until the expiration of the lease term null due to a contradiction with good morals?”
The high court, however, ruled that the assessment for validity of the penalty clause should be made case by case, taking into consideration the criteria in Interpretative Decision No. 1/2010 of the Supreme Cassation Court. At the same time, the Supreme Court declared the specific penalty clause to be null and void and justified this judgement on the fact that the tenant would indeed be unable to use the leased property but at the same time it shall not pay any rent.
In the opinion of the court, the amount of the damages suffered by the tenant is much lower compared to the penalty amount and this went beyond the immanent functions of a penalty. Thus, the penalty provision contradicted good morals and was deemed null.
As a result of this ruling, it appears that it is almost impossible to enforce penalty clauses by tenants or landlords. Even if the counterparty is passive and does not make the invalidity argument, courts are obliged to monitor the validity of such clauses ex officio.
But what can parties in a lease agreement do to protect themselves? To negotiate valid penalties, parties could seek guidance in the Interpretative Decision No. 1 of 2010 of the Supreme Cassation Court, which declared that the validity of a penalty clause should be assessed on a case-by-case basis with the following criteria considered crucial to the clause's validity:
The financial value of the obligations, secured by the penalty clause;
The type of penalty (for delay or substituting full performance);
The scale of the default (whether it is significant or insignificant); and
The ratio between the amount of the penalty and the damages, which the parties expect to receive as a result of the default.
When in doubt, parties to lease agreements should consider the above criteria when negotiating penalty clauses or consult legal advice. For more information on specific penalty clauses or the substance of the ruling described in this article, feel free to contact one of the following local CMS experts: Jenia Dimitrova and Zornitsa Stoykova.