In re Republic Airways Holdings Inc.: Unreasonable Liquidated Damage Clause Unenforceable Against Debtor and Guarantor

The following is a case update analyzing a recent decision of interest:

The bankruptcy court for the Southern District of New York held that certain liquidated damage clauses in an aircraft lease violate New York Commercial Code Article 2-A and, thus, are unenforceable as against public policy, not only against the lessee, but also as against the lessee’s guarantor. In In re Republic Airways Holdings Inc. 2019 WL 630336 (Bankr. S.D.N.Y. Feb. 14, 2019), the bankruptcy court granted summary judgment on the objection to the lessor’s claim on the grounds that the liquidated damage provisions were not reasonable in light of the anticipated harm from default measured at the time of the lease’s formation. To review the Memorandum of Decision, click here.

At issue were three optional liquidated damage provisions. Two employed a stipulated loss value (“SLV”) to be adjusted. Under the first, the damages were the SLV minus the present value of the fair market rental for the remainder of the lease term. The second calculated the damages as the SLV minus the fair market sales value of the aircraft. The first month’s SLV in each of the two provisions was the cost of the purchase of the aircraft. It was adjusted on a month-to-month basis but the adjusted SLV always provided the lessor with a four percent return on the aircraft purchase. At the expiration of the lease, there was no SLV or requirement that the lessee pay any reduction in the aircraft’s value. The lessee was simply required to return the aircraft.

The debtor rejected the leases under Bankruptcy Code section 1110 and objected to the lessor’s claims arising from this rejection. The court began its analysis with New York Commercial Code section 2-A-504(1) allowing damages from a loss of the lessor’s residual value to be liquidated in a lease but requiring those liquidated damages to be “reasonable in light of the then anticipated harm caused by the default….” Observing that the Commercial Code did not define “reasonable,” the court found that common law remains part of any test of reasonableness under Article 2-A. It continued, finding that reasonableness is measured on the date of the lease formation, that the court must give due consideration to the nature of the contract and the attendant circumstances, and that the liquidated damages must not be a penalty.

Here, the liquidated damage provisions at issue violated section 504 because “the liquidated damages provisions … 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.” Id., at *11. First, the liquidated damage provisions were not designed to compensate for default, but, instead, to protect the lessor’s investment in and its return on the purchase of the aircraft. As discussed above, at the expiration of the lease, there was no SLV or requirement that the lessee pay any reduction in the aircraft’s value.

Moreover, there was no causal link between the anticipated harm and the act of default. While section 2-A-504 does anticipate indemnification for loss of 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.” Id., at *13.

Finally, there was a huge disparity, particularly in the latter stages of the lease, between the amount due in future lease payments and the damages calculated under the liquidated damage provisions. As of the rejection, the debtor owed approximately $12MM in future lease payments, but the amount claimed by the lessor under the liquidated damage provisions exceeded $52MM. The lessor raised issues of the sophistication of the parties and the Commercial Code’s policy to allow freedom of contract, but the court rejected both. Because the liquidated damage provisions were unenforceable as against public policy, the court further found them unenforceable as against the guarantor.

This e-bulletin was prepared by Walter K. Oetzell, Walter K. Oetzell, APC, wkoetzell@oetzelllaw.com.