Huge Liquidated Damages Held Unenforceable in an Aircraft Lease

Bankruptcy Judge Sean H. Lane of Manhattan put a lid on liquidated damages in aircraft leases, holding that the lessor could not require the airline to pay the decline in market value of the aircraft in the event of breach when the lessor would bear the market risk if the aircraft were returned at the end of the term of the lease.

In his meticulously written 48-page opinion, Judge Lane also held that the lessor could not enforce an unconditional guarantee of the lease when the liquidated damages were unenforceable for violating public policy.

The Facts

Republic Airlines Holdings Inc. and its airline subsidiaries filed chapter 11 petitions. Near the end of the term of seven aircraft leases, an airline debtor rejected the leases and returned the aircraft.

The leases contained identical liquidated damages clauses. At the risk of gross oversimplification, suffice it to say that the liquidated damages provision obligated the airline to pay the rent for the remaining term of the lease, plus the difference between the so-called stipulated loss value and the lower market value of the aircraft at the time of breach. (Roughly speaking, stipulated loss value is the parties’ estimate of the value of the aircraft at specific times in the future.)

In other words, the lease required the airline to pay damages, including the amount by which the actual value of the aircraft at the time of breach was less than what the parties estimated the value would be when they entered into the lease years earlier.

Invoking the liquidated damages clauses, the lessor filed claims totaling about $55 million against the airline and an identical $55 million claim against the holding company on its unconditional guarantee. As Judge Lane said, the guarantee purported “to waive all defenses and generally establish the guarantee obligations [as] unassailable under all circumstances.”

The debtors objected to the claims and filed a motion for summary judgment, contending, as Judge Lane said, that the damages from rejection were “readily calculable and total only $5.7 million.”

The UCC Standard for Liquidated Damages

Until New York adopted UCC § 2A-504 in 1995, the validity of liquidated damages clauses was governed by common law. Generally, liquidated damages were enforceable if reasonable in light of anticipated probable harm and if actual damages would be difficult to ascertain at the time of contracting.

Section 2A-504 changed the law. It provides that damages “may be liquidated in a 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 . . . .”

Judge Lane said that the UCC carried over the common law notion of “reasonable,” although the UCC dropped the requirement that actual damages be difficult to estimate.

In substance, Judge Lane concluded that the liquidated damages formula was not “reasonable” at the time the parties signed the lease. Although the parties indisputably were sophisticated, he ruled that sophistication was “not dispositive on the question of reasonableness.”

Why was the clause deemed unreasonable? Judge Lane said that the liquidated damages provision transferred “residual value risk, or market risk, [to the debtor airline] only upon default, without a cognizable connection to any anticipated harm caused by the default itself.”

Later, Judge Lane explained that the airline would not be liable for the unanticipated decline in value of the aircraft if the airline had returned the aircraft at the end of the term of the lease. Had the lease run its course, he said, the airline “was simply obligated to return the Aircraft to the Lessor” without paying for the decline in market value.

Because the “plain language” of Section 504 requires a causal link between the anticipated harm and the default, Judge Land held that the formula was “an improper penalty rather than a liquidation of damages that is ‘reasonable in light of the then anticipated harm caused by the default . . . .’”

Judge Lane went on to say that liquidated damages could only cover a decline in residual value “that is linked to default, rather than by uncorrelated market factors.”

To drive the point home, Judge Lane pointed out the disparity between the unpaid rent until the end of the term compared to the liquidated damages. For one aircraft, for example, the remaining rent was only some $120,000 while the liquidated damages were about $5.7 million.

Although the liquidated damages were unenforceable against the airline, the lessor argued that the $55 million guarantee claim was enforceable against the parent holding company in view of the unconditional guarantee. Judge Lane disagreed, picking which of two competing principles of New York law he would follow.

On one hand, New York “provides for stringent enforcement of unconditional guarantees,” Judge Lane said. On the other, “courts have recognized limits to the enforcement of such guarantees under New York law.”

Judge Lane held that the guarantees could not be enforced “for the same reason as the underlying obligations: the liquidated damages clauses . . . violate public policy.”

In refusing to enforce the guarantee, Judge Lane had a problem. In a non-precedential opinion, the Second Circuit upheld a guarantee in 2016 even though it was based on an unenforceable penalty.

Judge Lane declined to follow the Second Circuit because, he said, it was “an unpublished, non-binding precedent.” Also, he said, the Second Circuit did not address any arguments based on public policy or statute.