The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A bankruptcy court in New York has held that a liquidated damages clause based on “stipulated loss value” contained in an equipment lease was void because the lessee’s liability was not connected to any losses caused by the lessee’s default; further, the clause could not be enforced against a guarantor, even though the guarantee contained broad waivers. [In re Republic Airways Holdings, Inc., 2019 Westlaw 630336 (Bankr. S.D.N.Y.).]
Facts: A corporation leased several airplanes. The leases contained liquidated damages clauses that depended upon the “stipulated loss value” or “SLV” of the equipment; the court later explained that the purpose of those clauses was to ensure that the lessor would receive a constant return on its investment, regardless of the condition of the equipment.
The lessee’s holding company executed guarantees of those leases. Those guarantees included provisions purporting to waive all defenses and to establish that the guaranteed obligations were unassailable under all circumstances.
Following the companies’ Chapter 11 filing, the lessor filed proofs of claim. The debtors objected, arguing that the liquidated damages provisions were unenforceable and that the guarantor could not be held liable for liquidated damages.
Reasoning: Citing the New York version of §2-A-504 of the Uniform Commercial Code, the court granted summary judgment in favor of the debtors. The court explained why the liquidated damages were unenforceable as penalties under the statute:
[T]he SLVs were calculated at the first month as equal to the purchase costs (price plus transaction expenses) of the Aircraft and adjusted monthly over the term of the Amended Lease to take into account payments of basic rent and tax benefits so that they were always equal to an amount that provided Lessor with a four percent return on the Aircraft purchase . . . . In other words, in the event of a default, this remedy formulation effectuated a transfer of 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.
Thus, the SLVs were calculated to achieve a four percent margin above the original purchase price regardless of where default may have left the parties . . . . Under that formulation, Lessee bore the risk of any loss of market or rental value of the Aircraft over the course of the Amended Lease, in addition to the fixed margin. Notably, the Amended Leases did not provide for a similar risk transfer at expiration of the lease term: absent an event of default, Lessee was simply obligated to return the Aircraft to Lessor, while ensuring compliance with the condition and maintenance requirements for that particular Aircraft.
The court explained that the liquidated damages clause was unconnected to the anticipated loss resulting from the lessee’s default:
[W]hile the statute may permit some form of indemnification for risk to residual value, such indemnification can only cover damage or loss to the residual value that is linked to default, rather than by uncorrelated market factors.
[T]he SLV obligations here do not purport to liquidate the damages stemming from a default or even seek to mimic them . . . . As [the lessor] concedes, “the Lessee agreed upon a default to repay the full amount of the outstanding financing, as adjusted by a 4% after tax interest rate, along with tax costs associated with an early termination of the Leases – the so called Unpaid Lease Financing Amount, less the fair market value of the Aircraft . . . .”
The lessor contended that because the leases in question were “financing leases,” rather than “true leases,” a different analysis should be applied. The court disagreed:
[S]imply put, the Court cannot square the particular liquidated damages clauses here with the requirements of [§2-A-504] – even considering the . . . Leases as finance leases—given that the pricing structure and risk allocations detailed above are untethered from the damages arising out of default.
The court then held that the guarantors could not be held liable for the unenforceable liquidated damages provision:
Given the weight of authority, this Court concludes that the Guarantees here are not enforceable for the same reason as the underlying obligations: the liquidated damages clauses in the Amended Leases violate public policy. Such a conclusion is consistent with case law from this Circuit holding that, as a matter of public policy, parties may not waive defenses to liquidated damages clauses . . . .
The lessor argued that the parties were extraordinarily sophisticated and that the guarantees contained stringent waivers, but the court was not persuaded:
Ultimately, the Court must balance the conflict between two significant and conflicting legal precepts: the validity of unconditional guarantees and the interest of public policy. While the Court acknowledges the importance guarantees play in the realm of leasing and equipment financing, these values cannot overcome the long-expressed mandate that precludes parties from contracting to something privately that is disallowed by public policy and explicit statute.
Author’s Comment: With reference to the liquidated damages provision, I do not see how the lessor could have drafted the clause to achieve its desired result (an absolutely fixed rate of return to the lessor) without running afoul of the statute. Assuming this decision withstands review, lessors will probably start using less-ambitious clauses, on the theory that getting something is better than getting nothing. See Finance Inv. Co. (Bermuda) Ltd. v. Geberit AG, 165 F.3d 526, 534, 42 Fed. R. Serv. 3d 515 (7th Cir. 1998): “[P]igs get fat, but hogs get slaughtered.”
Turning to the enforceability of the “unconditional” guarantee, this decision is in line with the overall trend in the caselaw: regardless of what the guarantee says, courts will be reluctant to enforce clauses that are void as against public policy. For a valuable discussion of waivers by guarantors, see David E. Hackett, Guaranteed Confusion: The Uncertain Validity of Suretyship Defense Waivers in California, 41 Loy. L.A. L. Rev. 1097 (2008).
For discussions of cases dealing with related issues, see:
- 2018-23 Comm. Fin. News. NL 46, Guarantors’ Broadly Worded Waivers Preclude Assertion of Legal Defenses But Not Equitable Defenses.
- 2014-50 Comm. Fin. News. NL 100, Construction Lender is Liable to General Contractor Due to Misleading Promises of Payment, and Guarantors Are Exonerated by Lender’s Misconduct.
- 2007 Comm. Fin. News. 67, Lender Cannot Invoke “Shared Appreciation” Exception to Usury Laws Because Additional Interest Is Not Really Contingent; Guarantor’s Waiver of Usury Defense Is Ineffective.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.