The issue of liquidated damages often confronts lenders seeking to recover for their losses when a borrower defaults or chooses to exit a facility prior to its contracted maturity date.  Liquidated damages provisions are enforceable, but only at an amount that is reasonable in light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss in such circumstances.

Courts have considered the reasonableness and applicability of these provisions in various contexts and in all kinds of courts.  A very recent decision from the Bankruptcy Court for the Southern District of New York is one of interest to readers of this publication.  The case involves the lease of several aircraft to a commercial airline.

Lessor purchased seven aircraft that were then leased to a commercial airline.  Shortly after the airline filed its Chapter 11 it rejected the seven aircraft leases and surrendered them back to the Lessor.  The Lessor filed a proof of claim for its rejection damages which proof of claim included liquidated damages as provided for in the leases.  The debtor airline filed objections to the proof of claim and, on February 14, 2019 (Valentine’s Day), the Court issued its decision on the motion for summary judgment deciding the issues.

Because this involved a leasing transaction Article 2A of the UCC came into play.  Even so, the controlling section of Article 2A is consistent with general law on the topic of liquidated damages.  Section 504 of Article 2A provides:

Damages payable by either party for default, or any other act or omission, including indemnity for loss or diminution of anticipated tax benefits or loss or damage to lessor’s residual interest, may be liquidated in the lease agreement but only at an amount or by a formula that is reasonable in light of the then anticipated harm caused by the default or other act or omission.

The Court characterized the liquidated damages provision as follows:

The Lessee then has the choice of liquidated damages as measured in three different ways which make reference to various calculations of rent and stipulated loss value:

(i) Stipulated loss value minus present value of the fair market rental value for the remainder of the Amended Lease term;

(ii) Stipulated loss value minus the fair market sales value of the Aircraft; or

(iii) Difference between present value of rent reserved for the remainder of the Amended Lease term and the fair market rental value for the remainder of the term

The UCC, however, does not define reasonableness and as you would expect, the parties disagreed leaving it to the Court to decide.

Prior to Article 2A’s enactment, liquidated damages clauses in leases were governed by the common law. The common law provided that to be enforceable a liquidated damages clause must specify a liquidated amount which is reasonable in light of the anticipated probable harm, and that actual damages must be difficult to ascertain as of the time the parties entered into the contract.

Courts have upheld liquidated damage provisions so long as the amount liquidated bears a reasonable proportion to the probable loss and the amount of the actual loss is incapable or difficult of precise estimation.  If, however, the amount liquidated is plainly disproportionate to the probable loss, the provision will be deemed an unenforceable penalty

Under the Common Law a three part test was applied to consider reasonableness:

  1. Reasonableness must be judged at the time of contract formation;
  2. Due consideration must be given to the nature of the contract and the attendant circumstances; and
  3. The liquidated damages clause cannot be a penalty.

It is interesting to note that the Official Comments to Article 2A discuss eliminating the second and third prongs to this test.  Notwithstanding, the court turned to the common law for guidance as well as how other courts in similar situations treated liquidated damages since the enactment of Article 2A.

Courts have identified certain formulations as inherently unreasonable. For example, static liquidation values (“SLVs”) (i.e., where the SLV does not decline over the course of the lease term and thus fails to recognize depreciation and the payment of rent over time) have been repeatedly rejected.

The Court was clearly concerned with the propriety of the liquidated damages provision, saying:

At the center of the parties’ dispute is the fact that the liquidated damages provisions here allow for the unconditional transfer of residual value risk, or market risk, only upon default, without a cognizable connection to any anticipated harm caused by the default itself. …the question is “whether the parties in a true finance lease transaction can allocate risk so that the financing is treated as a debt obligation until the end date of the Leases, and then at the end of the term the Lessor Parties becoming the true economic owners.” …. Applying the applicable legal principles above to the SLVs in the Amended Leases, the Court concludes that the parties may not allocate risk where—as here—doing so violates the reasonableness requirement of Article 2A, Section 504.

The Court found that this approach transferred all market risk, or residual value, including any risk of idiosyncratic depreciation or damage to a particular aircraft. This provision granted Lessor the ability to retake possession of the aircraft and recover not just a dollar value equal to scheduled rental payments, but also any deficit in the value of the aircraft that fell short of Lessor’s desired total gross return. The SLVs were calculated to achieve a four percent margin above the original purchase price regardless of where default may have left the parties.  The Court noted:

The unreasonableness of the liquidated damages clauses here per Article 2A is confirmed by a comparison of the SLVs with the dollar value of the Debtors’ remaining rent obligations. Using the rent obligations set forth in the [o]riginal [l]eases, the numbers show a stark difference between the rent obligations that remain unpaid here—near the end of the lease term—as compared with the corresponding SLVs.

The Court itemized damage calculations that appeared to be out of line with the actual loss incurred by the Lessor.  One example showed an SLV of $ 6,358,502.68 on March 23, 2019, the last month of the lease term, when only $ 115,626.08 remained in basic rent obligations.

The Court concluded that the liquidated damages clauses operated as a penalty contrary to the spirit of a traditional liquidated damages provision and dismissed the Lessor’s claims.

Bank and ABL early termination provisions typically provide for a declining percentage of the maximum loan amount.  Those provisions consistently are upheld as being reasonable.  The takeaway from this decision, however, is be cautious in your liquidated damages provisions so as to assure that you obtain the benefit of your bargain and not imposing a penalty.

In Re: Republic Airways Holdings Inc.,  2019 WL 630336, (Bankr. NY 2019)

Leave a Reply

Your email address will not be published. Required fields are marked *