New York Bankruptcy Court Strikes Liquidated Damages Provision and Related Guarantee as Unenforceable Penalty

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New York bankruptcy court cautions against liquidated damages provisions that are “invariant to the gravity of the breach.”

TAKEAWAYS

  • Liquidated damages provisions must be based on a “causal link” between the anticipated harm and the act of default.
  • A liquidated damages provision that shifted the risk of depreciation in residual value from lessor to lessee was an unenforceable penalty.
  • A related unconditional guarantee is unenforceable where the underlying obligation violates public policy

In the Republic Airways bankruptcy, Judge Sean H. Lane of the U.S. Bankruptcy Court for the Southern District of New York (the “Court”) struck down a liquidated damages provision as an unenforceable penalty under the New York Uniform Commercial Code (UCC). (See In re Republic Airways Holdings Inc., 598 B.R. 118 (Bankr. S.D.N.Y. 2019).) The dispute arose from the debtors’ rejection of seven aircraft leases. Rejection triggered a liquidated damages provision identical in each contract. The provision entitled the lessor to unpaid rent plus liquidated damages calculated using a stipulated value assigned to each aircraft (the “Stipulated Value”). Upon default, the lessor could choose one of three different formulas in calculating its liquidated damages:

  1. the Stipulated Value of each aircraft minus the present value of the fair market rental value for the remainder of the lease term;
  2. the Stipulated Value minus the fair market sales value of the aircraft; or
  3. the difference between the present value of rent for the remainder of the lease term and the fair market rental value for the remainder of the lease term.

The liquidated damages provisions allowed the lessor to retake possession of each aircraft, recover remaining rental payments, and receive any deficit in the aircraft’s value that fell short of the Stipulated Values.

Upon rejection of the leases, the lessor filed (i) seven claims for more than $55 million for damages arising from the rejection of the leases and (ii) seven identical claims for more than $55 million against the debtors’ parent on account of the parent’s unconditional guarantee of the lease obligations. The debtors objected and estimated that the lessor actually suffered only a fraction of the amount sought in its claims.

The Court decided two issues: (i) whether the liquidated damages provision violated Article 2A of the UCC and was therefore unenforceable as against public policy and (ii) if so, whether the guarantor of the lease obligations is liable for the unenforceable liquidated damages.

The UCC’s Reasonableness Requirement
As a threshold matter, the parties agreed that the finance leases were “true leases” and therefore governed by Article 2A of the UCC. Article 2A, section 504 of the UCC requires the liquidated damages provision to be reasonable in light of the harm from a default that is anticipated by the parties at the time of the transaction. The Court articulated several principles for assessing “reasonableness”:

  • Reasonableness must be judged at the time of contract formation.
  • The court must consider the nature of the contract and the attendant circumstances.
  • The liquidated damages provision must be reasonable in light of the harm from a default that is anticipated by the parties at the time of the transaction, and thus must not be a penalty.
  • Certain liquidated damages formulas are inherently unreasonable, such as those provisions that are “invariant to the gravity of the breach.”

The Court found the liquidated damages provision was unenforceable because of the absence of a “causal link” between the anticipated harm and the act of default. The provision not only granted the lessor the ability to retake possession and recover scheduled rent payments, but also recover any deficit in the value of the aircraft that fell below the Stipulated Value. The provision shifted the market risk (i.e., the risk of a decrease in the aircraft’s residual value) from the lessor to the lessee, notwithstanding the amount of damages suffered as a result of rejection. The Court noted the stark contrast between the damages sought and the remaining rent obligations under the leases. The lessor sought $52.7 million but were owed only $12.585 million in unpaid rent for all seven leases.

The Court rejected an argument by the lessor that the parties’ expectations in finance leases are unique and therefore affect what is “reasonable” within the meaning of section 504. Because lessors in such transactions are primarily providing financing, the lessor argued, the allocation of risk effectuated through the liquidated damages provision is reasonable as long as the parties agreed to it. The Court acknowledged precedent within the Second Circuit to support this argument. In Wilmington Tr. Co. v. Aerovias de Mexico, S.A. de C.V., 893 F.Supp. 215 (S.D.N.Y. 1995), a liquidated damages provision in an aircraft finance lease was upheld because the funds were used to pay noteholders, and therefore the provision was reasonable considering the overall structure of the transaction. In Aerovias, the court noted the relevance of the parties’ sophistication and the existence of experienced counsel who negotiated the contract at arm’s length. The Court found that the parties’ sophistication was relevant though not dispositive on the question of reasonableness.

The Guarantor’s Liability for Liquidated Damages
Next, the Court addressed whether damages were recoverable under the guarantee claims notwithstanding the unenforceable damages provision.

The Court found the guarantee was also unenforceable because public policy defenses may not be waived under a guarantee. The Court balanced two conflicting legal precepts: on the one hand, the absolute and unconditional language of the guarantees, which purported to waive all defenses against the lessor and render “the guarantee obligations unassailable under all circumstances,” and the interests of public policy on the other. The Court noted that, despite the importance of the guarantees for leasing and equipment financing, their importance “cannot overcome the long-expressed mandate that precludes parties from contracting to something privately that is disallowed by public policy and explicit statute.”

Notably, the lessor relied upon an unpublished Second Circuit decision, 136 Field Point Circle Holding Co., LLC v. Invar Intern. Holding, Inc., 644 Fed. App’x 10 (2d Cir. 2016), which upheld an unconditional guarantee notwithstanding that the underlying obligation constituted an unenforceable penalty. The Court declined to rely upon 136 Field Point as unpublished, non-binding precedent. In addition, the decision in 136 Field Point was distinguishable because it did not address any argument based on public policy or statute.

Conclusion
Judge Lane’s decision serves as a reminder of the scrutiny that liquidated damages provisions and related guarantees can receive from courts if challenged. Parties should be mindful of the “causal link” between the anticipated harm and the act of default. Absent a “causal link,” a court may be willing to take a closer look at whether the liquidated damages provision is reasonable.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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