By:Alana Porrazzo, an attorney with Jennings Haug Cunningham

On February 14, 2019, the United States Bankruptcy Court for the Southern District of New York ruled that a type of liquidated damages provision commonly found in equipment leases was unenforceable under Section 2A-504 of the Uniform Commercial Code. See In re Republic Airways Holdings, Inc., Case No. 16-10429 (SHL), 2019 WL 630336 (Bankr. S.D.N.Y. Feb. 14, 2019).

Like many other equipment leases, the aircraft leases at issue in this bankruptcy allocated the risk of market depreciation and damage to the lessee in the case of default. If the lessee defaulted, the lessor could demand return of the aircraft and payment of all unpaid rent, as well as the difference between a “stipulated loss value” (SLV) and the fair market value of the aircraft at that time. SLVs were adjusted monthly over the term of the lease ‘so that they were always equal to an amount that provide Lessor with a four percent return[.]” In other words, upon default, the lessor not only could recover unpaid rental payments and the equipment itself, but also “any deficit in the value of the Aircraft that fell short of Lessor’s desired total gross return.”

Under the aircraft leases, the disparities between SLVs and basic rent obligations grew wider and wider as the lease term progressed. For example, for one particular aircraft, basic rent amounted to just shy of $125,000 in the final month of the lease. Meanwhile, the scheduled SLV value for the same month eclipsed $6.3 million (a multiple of over 54x).

Further, the leases did not contain reciprocal risk-shifting provisions; absent an event of default, the lessee was simply obligated to return the aircraft to the lessor at the end of the lease term.

The bankruptcy court looked to the Uniform Commercial Code (UCC) when assessing the enforceability of the leases’ SLV provisions. Finding that the aircraft leases were “true leases,” the bankruptcy court determined that Article 2A-504 supplied the relevant standard, namely that “[d]amages . . . for default . . . 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.” See N.Y. U.C.C. Law § 2-A-504(1); see also A.R.S. § 47-2A504 (for the identical enactment of the UCC).

Construing this “reasonableness” requirement further, the In re Republic Airways court found that (i) “reasonableness must be judged at the time of contract formation;” (ii) courts must “give due consideration to the nature of the contract and the attendant circumstances,” including the sophistication of the parties; and (iii) courts must ensure that “the provision is neither a penalty nor a forfeiture,” by comparing liquidated to actual damages.

The court ultimately found that the SLV obligations were unenforceable because they were not “reasonable in light of the then anticipated harm from default.” Indeed, the SLVs bore no correlation to the anticipated harm the lessor would suffer if the lessee defaulted. (The SLV formula “[did] not purport to liquidate the damages stemming from a default or even seek to mimic them.”) Moreover, the sheer disproportionality between SLV values and remaining rental payment values did the lessor no favors when it came to the court’s “reasonableness” analysis.

In re Republic Airways suggests that equipment lessors would do well to revisit their leases with an eye to ensuring that liquidated damages bear the required “causal link” to the anticipated loss in the event of default. A stipulated loss value formula is not per se unenforceable, but it “remains curbed by the requirement that the liquidated damages be reasonable.”