Liquidated damages or stipulated loss provisions, through which parties stipulate to damages based upon the date of breach, are standard in the commercial leasing industry. Such provisions provide the parties with important benefits, including a definite forecast of lessor’s damages in the event of lessee’s default, which in turn provides greater certainty prior to entering into the lease so they can make an informed decision as to whether the lease makes economic sense. Moreover, such provisions can help to reduce the costs of litigating the lessor’s damages should lessee default with the matter ending up in court.

Despite these economic benefits, certain jurisdictions such as Texas have long been hostile to enforcement of such clauses. However, judicial hostility – or at lease strict scrutiny – has recently extended to more commercially oriented states. Which means a lessor may still have to prove actual damages at trial.

For example, in In re Montgomery Ward Holding Corp., 326 F.3d 383 (3d Cir. 2003), the Court of Appeals recently affirmed a lower court’s ruling that a casualty value liquidated damages clause contained in an equipment lease was an unenforceable penalty under Illinois law. The bankruptcy court granted the debtor’s motion to reject an equipment lease with 10 months remaining. The lease contained a liquidated damages clause, providing for the lessor’s recovery of the casualty value of the equipment as of the monthly rent date following the default calculated in accordance with schedules to the lease. The lease also contained an Illinois choice of law provision and provided that the debtor was not obligated to renew its lease or to purchase any of the equipment.

The bankruptcy court granted the lessor’s claims, but the district court reversed on the ground that the casualty value provision was an unenforceable penalty. The Third Circuit affirmed, also finding that the provision was an unenforceable penalty. The Circuit Court cited Illinois’ version of the Uniform Commercial Code, 810 ILCS 5/2A-504, which provides that damages may be liquidated but only at an amount "reasonable in light of the then anticipated harm caused by the default[.]" The court concluded under this provision, the "consistent approach to all damages issues is that the victim of a breach cannot be placed in a better position than it would have occupied if the contract had been performed."

The court noted that the lessor’s claim for payment including the casualty values was $3.5 million plus - more than $2 million greater than its recovery had debtor performed under the lease, and this represented "a graphic demonstration of the penalty represented by the casualty value provisions."

In another recent decision, Eplus Group Inc. v. Panoramic Communications LLC , 2003 WL 1572000 (S.D.N.Y. March 27, 2003), the court denied a lessor’s motion for a declaration that a liquidated damages clause contained in a commercial lease was enforceable under Virginia law pursuant to the lease’s choice of law provision. The court noted that the Uniform Commercial Code and Virginia’s version provide that the measure of damages under a default should place lessor in as good a position as performance would have, and that the damages must be reasonable in light of the anticipated harm.

In finding that the defendants had raised issues of fact, the court noted that plaintiff’s recovery in the event of default with inclusion of liquidated damages was approximately three times the amount of lease payments plaintiff did not receive as a result of the default. The court further noted that plaintiff had failed to rebut defendants’ contention that the equipment at issue, three-year-old used computer equipment, had a negligible sale or re-lease value.

Montgomery Ward and Eplus sound a note of caution with regard to the prima facie enforceability of liquidated damages provisions in commercial leases. The following suggestions, however, may help to reduce the likelihood that a liquidated damages provision will be deemed unenforceable:

a) Draft liquidated damages provisions so that they do not allow lessor to recover significantly more in the event of lessee’s default compared with lessor’s recovery if lessee had fully performed.

b) Review existing leases for stipulated loss provisions providing for recovery in the event of a default far in excess of lessor’s recovery had lessee fully performed. Amend existing leases as necessary.

c) Draft leases so that they do not provide for recovery of liquidated damages in the event of a minor breach. Limit defaults which trigger liquidated damages to breaches central to the lease, such as the failure to make monthly rental payments. Amend existing leases as necessary.