Reed Smith Client Alerts

In a decision with sweeping consequences for equipment lessors, the bankruptcy court (SDNY) in Republic Airways held that a liquidated damages provision in a true lease is an unenforceable penalty if it provides 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. Importantly for lessors and lenders alike, the bankruptcy court held that the unconditional guaranties of such obligations in favor of the lessor violated public policy and were unenforceable.

Autoren: Richard J. Tannenbaum Debra S. Verstandig Robert M. Vilter

Background

The agreements at issue were true finance leases (aircraft leases) that had been rejected in the bankruptcy case. The leases provided that, upon default, the lessee must pay (i) any unpaid basic rent for the aircraft plus (ii) liquidated damages. The leases calculated liquidated damages in one of three ways:

  1. the stipulated loss value minus the present fair market rental value of the aircraft for the remainder of the lease term; or
  2. the stipulated loss value minus the fair market sales value of the aircraft;1 or
  3. the present value of the rent reserved for the remainder of the lease term minus the fair market rental value of the aircraft for the remainder of the lease term.

The stipulated loss values were calculated monthly, with the first month’s being the original purchase cost of the aircraft and every month thereafter an amount that yielded the lessor a 4 percent return on those original costs. In the final month of each lease, the stipulated loss value equaled the residual value that the lessor needed to realize from the aircraft to achieve its 4 percent return. By contrast, in a non-default scenario, at the end of the lease term the lessee was only required to return the aircraft; the lessee was not charged for any decline in residual value.

The issues as framed by the bankruptcy court were (i) whether the liquidated damages provisions in the leases violated article 2A of the New York Uniform Commercial Code (NY UCC) and, therefore, were unenforceable against the debtor-lessee; and, (ii) if so, whether the debtor-guarantor was still obligated to pay those unenforceable liquidated damages under its absolute, unconditional guaranty, which included a waiver of defenses.