It happened again. This time, not simply via an oral ruling by a judge from the bench, but in a written opinion, for all the world to see. And even though the litigants settled their differences after the decision was published, the opinion still remains on the books.

The decision, In re Republic Airways Holdings Inc., 2019 WL 630336, was issued February 14, 2019. But it was not a Valentine to the equipment finance world–more like a skunk at a garden party. This article will describe the business and legal background of the case, and discuss why the decision was flawed.

Readers of the July/August 2018 issue of The Monitor were startled to learn that a bankruptcy court judge in Delaware, in In re Tidewater Inc., had challenged the validity of using stipulated loss values as a reasonable measure of the lessor’s damages following Tidewater’s bankruptcy and rejection of bareboat charters (leases) for sixteen offshore support vessels used in the offshore energy exploration and production business. Each of the six leases for the vessels provided that one of the lessor’s remedies upon the lessee’s default was the right to receive liquidated damages equal to the stipulated loss value (SLV) for the month in which the default occurred. These values typically are expressed as a percentage of the lessor’s cost of the items of equipment suffering a casualty or for which the lessee was terminating the lease in advance of the scheduled expiration date. Both the lessors and the lessee agreed upon using these schedules as a measure of liquidated damages, but after Tidewater filed for Bankruptcy Code protection and rejected the leases, it asserted that the SLV amounts were not a reasonable formula for measuring the lessor’s liquidated damages in a default context.

What Are Liquidated Damages?

Under Uniform Commercial Code (UCC) Article 2A (Leases), a lessor’s remedies upon an event of default (by the lessee) may include:

• past due rent;

• present value of remaining rentals;

• damages for loss or reduction of anticipated tax benefits;

• damages for any loss or reduction in the lessor’s residual interest in the equipment; and

• enforcement expenses, such as legal and repossession costs.

UCC section 2A-504 provides that damages “may be liquidated in the lease agreement but only at an amount or by a formula that is reasonable in light of the then [i.e., at the outset of the lease term] anticipated harm caused by the default” (emphasis added).

The Official Comment to section 2A-504 observes that a common liquidated formula includes the sum of the above five elements “less the net proceeds of disposition (whether by sale or re-lease) of the leased goods,” and mentions that a common formula “utilizes a periodic depreciation allocation as a credit” in lieu of the actual net proceeds of disposition.

The Comment also notes that “stipulated damage schedules are also common [but] will be [enforceable] in the context of each case by applying a standard of reasonableness in light of the harm anticipated when the formula was agreed to” (emphasis added). Once again, reasonableness is determined when the lease commences, rather than at the time of default.

So What’s Wrong With Using the SLV Table?

The Tidewater lessors used the agreed-upon SLV amounts when they filed claims for damages in the bankruptcy proceedings. Tidewater objected, asserting that the SLV was not a reasonable measure of the lessor’s damages. It observed that, if it had breached one of the leases in the final month of its term, then it would be liable for $203 million in damages, whereas the remaining rent would have been only $3 million. Of course, Tidewater neglected to mention that the SLV was calculated to make the lessor whole (for loss of its anticipated residual value in the vessel, among other losses) if the vessel sank to the bottom of the ocean, and that in a default context the lessee would be credited with the resale proceeds of the vessel. But the bankruptcy judge apparently bought into Tidewater’s argument.

In fairness to that judge, he was relying on earlier decisions of the Third Circuit Court of Appeals, whose jurisdiction includes Delaware. In re Montgomery Ward Holding Corp., a 2003 decision (326 F.3d 383) had denied the lessor’s claim for casualty value damages, where the lease contained no such reduction in the lessor’s damages for the actual net resale proceeds of the equipment. The lease also contained another flaw. The casualty value table was calculated only on an annual basis rather than the monthly basis on which rentals were paid. This produced the odd result that if a casualty (or default) occurred during the final month of the three-year term, then the lessee would be obligated to pay $3,067,460—for equipment which cost $6,070,923. Faced with these two flaws, the court ruled that, under Illinois law governing the lease, using the casualty value numbers constituted an impermissible penalty, rather than a formula which was “reasonable in light of the then anticipated harm caused by the default.”

In 1998, the same Third Circuit Court of Appeals had applied New York law to reject another liquidated damages clause (In re Trans World Airlines, Inc., 145 F.3d 124), even though the remedies section of the lease contained an offset for the fair market rental value or the fair market sales value. Under New York law, a damages formula will be upheld “if the amount liquidated bears a reasonable proportion to the probable loss and the amount of actual loss is incapable or difficult of precise estimation.” The TWA court observed that the termination value in the aircraft lease constituted an impermissible shifting of the “risk of a market drop in the Aircraft’s value”. The court noted that, when TWA defaulted in 1992, “the airline industry was severely depressed” and hence that the termination value would impose upon TWA substantial liquidated damages, even after deducting the fair market sales or rental value.

The Republic Case

In Republic Airways, much like Tidewater, the bankrupt lessee rejected seven aircraft leases and objected when the lessor used the agreed-upon SLV amount in submitting its claim for damages. The lessee asserted that the lessor’s sole remedy was for the present value of the remaining rent, and that for it to pay the SLV would compensate the lessor for the decline in the fair market value of the aircraft during the (truncated) lease term. The court applied the Tidewater analysis to compare the SLV and the remaining basic rent, during the final month of each of the leases, and determined that the former were roughly fifty multiples of the latter. Although the lessors argued that the high SLVs merely reflected the bargained-for allocation of risk between the lessee and lessor (so that the lessor would receive a 4% rate of return on its investment, should a casualty or a default arose), the court cited section 2A-532 to the effect that a lessor’s damages may include “an amount that will fully compensate the lessor for any loss of or damage to the lessor’s residual interest in the goods caused by the default of the lessee.” The court ruled that the liquidated damages provisions of the leases “violate public policy and constitute unenforceable penalties in violation of” UCC section 2A-504.

The court dismissed arguments that the leases were “finance leases” and hence entitled to the benefits of UCC section 2A-407, along with the “hell or high water” clause of the leases, and ruled that “[s]uch a view improperly reads [UCC 2A-504] out of the statute. In a final blow to the transaction structure, the court ignored a long line of case law and, citing pre-UCC decisions from 1908 and 1934, held that the hell or high water guaranty would not be construed to enforce against the guarantor, the very liquidated damages provision which the court had just held was an unenforceable penalty.

What Can Lessors Do Now?

On its face, the decision appears to be disastrous for any equipment lease which (to avoid a slugfest in court over proving actual damages) uses an agreed-upon table of declining amounts payable by a defaulting lessee. But Republic Airways is noteworthy not only for what it overlooked, but also for the road map which it provided for documenting future deals.

First of all, the decision paid no attention to the usual deduction, from the agreed-upon liquidated damages formula, for the resale proceeds of the leased equipment (the Montgomery Ward lease had no such offset). Every lease should make this deduction abundantly clear.

Second, lessors — especially those of large, expensive equipment such as aircraft — should create a default value formula which is comprised of several elements: 1) the PV of remaining basic term rent; plus 2) remarketing damages, consisting of a) the anticipated residual value of the equipment during each monthly rent period; minus b) the actual sales value of the equipment; plus c) the actual cost of restoring the equipment to good condition (as required by all leases); plus d) the lessor’s reasonable cost of enforcing the lease and recovering the equipment. The damages section would have the lessee acknowledge that the monthly rentals were established upon the lessor’s reliance that the lessee would perform its obligations and that if an EOD occurred prior to the lease expiration date, then the lessor would suffer additional harm (arising from the lessee’s default) from having to remarket the equipment earlier than the bargained-for expiration date. This concept of remarketing damages was floated in footnote 19 (and accompanying text) to the Republic Airways decision and if calculated properly (such as avoiding a disparate damage claim if EOD occurs during the final months of the lease term) would avoid the “disparity” which that court observed between the casualty value and the remaining rent during the final month of the lease term.

Third, the hell or high water clause in the lease should refer expressly (“including, without limitation”) to the EOD damages calculation formula and require the lessee to acknowledge that, at the time that the lease was entered into, the default value formula is reasonable in light of the then anticipated harm caused by the lessee’s default under the lease.

Finally, any guaranty of the lease not only should contain the usual hell or high water and waiver of defenses clauses, but also acknowledge that the EOD damages formula in the lease is a reasonable means of calculating the lessor’s damages caused by the lessee’s default.

The uproar which followed the Republic Airways decision has required all lessors to rethink their remedies provisions. Nothing in this article constitutes assurance that its suggestions would be upheld by bankruptcy courts in New York, Delaware or elsewhere. But it is clear that lessors no longer can continue to rely reflexively on casualty values as a proxy for calculating damages after the lessee has triggered an event of default. •