In a decision with sweeping consequences for equipment lessors, the United States Bankruptcy Court for the Southern District of New York (SDNY) in Republic Airways held that a liquidated damages provision in a true lease is an unenforceable penalty if it provides 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. Importantly for lessors and lenders alike, the bankruptcy court held that the unconditional guaranties of such obligations in favor of the lessor violated public policy and were unenforceable.
The agreements at issue were true finance leases (aircraft leases) that had been rejected in the bankruptcy case. The leases provided that, upon default, the lessee must pay (i) any unpaid basic rent for the aircraft plus (ii) liquidated damages. The leases calculated liquidated damages in one of three ways:
- the stipulated loss value minus the present fair market rental value of the aircraft for the remainder of the lease term; or
- the stipulated loss value minus the fair market sales value of the aircraft;1 or
- the present value of the rent reserved for the remainder of the lease term minus the fair market rental value of the aircraft for the remainder of the lease term.
The stipulated loss values were calculated monthly, with the first month’s being the original purchase cost of the aircraft and every month thereafter an amount that yielded the lessor a 4 percent return on those original costs. In the final month of each lease, the stipulated loss value equaled the residual value that the lessor needed to realize from the aircraft to achieve its 4 percent return. By contrast, in a non-default scenario, at the end of the lease term the lessee was only required to return the aircraft; the lessee was not charged for any decline in residual value.
The issues as framed by the bankruptcy court were (i) whether the liquidated damages provisions in the leases violated article 2A of the New York Uniform Commercial Code (NY UCC) and, therefore, were unenforceable against the debtor-lessee; and, (ii) if so, whether the debtor-guarantor was still obligated to pay those unenforceable liquidated damages under its absolute, unconditional guaranty, which included a waiver of defenses.
The Court’s Decision
The bankruptcy court’s finding that the liquidated damages was an unenforceable penalty under NY UCC 2A-504 was based on its determination that there was no causal link between the anticipated harm and the event of default. The bankruptcy court found that allocating risk to the lessee during the term of the leases violated the reasonableness requirement of NY UCC 2A-504. According to the bankruptcy court, “the [stipulated loss value] obligations here do not purport to liquidate the damages stemming from a default or even seek to mimic them.” While the bankruptcy court recognized that NY UCC 2A-504 may permit some form of indemnification for risk to residual value, it stated that such indemnification can only cover damage or loss to the residual value that is linked to default, rather than by uncorrelated market factors.
As to the guaranty, while acknowledging clear NY precedent finding unconditional guaranties enforceable notwithstanding the unenforceability of the underlying obligation, the court held the lessor could likewise not recover as a matter of public policy because parties may not waive defenses as to liquidated damages clauses.
Thoughts and Takeaways
The bankruptcy court, as with the courts in the TWA and Tidewater cases (oral opinion, no order), failed to analyze the lease transactions as a whole when considering the enforceability of the liquidated damages provisions following an event of default, since it did not take into consideration the substantial economic benefits to the lessee – in the form of lower payments as compared to a loan and off-balance sheet treatment – from the true lease structure. These benefits were tied directly to the anticipated residual value of the leased property, the recovery of which by the lessor was included as a component of the (unenforceable) liquidated damages calculation. Further, one will likely find a direct correlation between, on the one hand, a decline in the lessee’s business and operations and a decrease in the value of the leased property due to market conditions in the lessee’s business; and, on the other, the event of default. Therefore, the inclusion of the anticipated residual value as a component of liquidated damages with the transfer of market risk during the term of the lease is reasonable as of the inception of the lease given the likely harm to the lessor as a result of the default and the factors giving rise to the default.
As to the unenforceability of the unconditional guaranties, given the clear precedent under NY law, one must consider whether the bankruptcy court erred by applying federal law precedent holding that, as a matter of public policy, parties may not waive defenses to liquidated damages clauses. At a minimum, in a case in a NY court, NY precedent should control. Finally, the bankruptcy court did not discuss the actual damages due the lessor given the unenforceability of the liquidated damages provision. One must wonder whether the actual damages allowed in In re Montgomery Ward (see prior blog post) would be followed by the bankruptcy court in Republic Airways.
Richard J. Tannenbaum (Temple B.A.) is a partner in Reed Smith’s Financial Industry Group. Richard’s practice focuses on credit and risk issues arising in equipment finance transactions. He has experience working with both international and U.S. deals.
Debra S. Verstandig is counsel in Reed Smith’s Financial Industry Group. Her practice centers around financial services litigation and commercial dispute resolution, providing litigation, credit risks, and restricting counsel to a range of institutional lenders and investors.
Robert M. Vilter is a partner in Reed Smith’s Energy and Natural Resources Group. He represents developers, borrowers, manufacturers, and financial institutions in a wide array of energy, infrastructure, and commercial finance matters.