The Dilemma of Liquidated Damages: Even after Default, Fairness Remains a Key Component of Enforceability

The AAR decision highlights how courts continue to struggle with interpreting UCC Article 2A's remedy provisions and emphasizes the delicate balance drawn between crafting a liquidated damage provision that affords the lessor the benefit of its bargain and one that will be struck down as an unenforceable penalty.

The underlying facts of the AAR case are fairly common. In May 1998, AAR, as lessor, entered into an Aircraft Lease Agreement (the “Lease”) with Vanances Heliades S.A., as lessee (“VH”) for a term of 96 months covering a Boeing 737 aircraft. The Lease had a fixed monthly rent component of $275,000 per month. VH in turn subleased the aircraft to Nimelias Enterprises S.A. (“NE”), which in turned sub-subleased it to Princess Airlines. Both the sublease and sub-sublease arrangements were known to AAR with each of VH and NE assigning all of their rights, title and interest under the sublease and sub-sublease, respectively, to AAR. Only several months after the commencement of the Lease, AAR alleged that VH was in default of the Lease for various reasons including VH's failure to make timely payments, the existence of unpermitted liens on the aircraft and VH's failure to maintain the aircraft in accordance with the terms of the Lease (among others). As a result of these breaches, AAR cancelled the Lease in September 1999 and sought to exercise its cumulative remedies ' including repossessing the aircraft and seeking payment of liquidated damages as stipulated in the Lease.

The pertinent part of the liquidated damages provision of the Lease that the AAR court examined reads as follows:

Whether or not Lessor shall have exercised or shall at any time thereafter exercise any of its rights [to repossesses the aircraft], Lessor by written notice to Lessee specifying a payment date not earlier than five (5) days from the date of such notice, may demand that Lessee pay Lessor, and Lessee shall pay Lessor, in addition to such other remedies, as liquidated damages for loss of a bargain and not as a penalty, an amount equal to Base Rental, Variable Rental, and other charges unpaid as of the date of such notice, plus an amount equal to the entire Base Rental for the duration of the unexpired period remaining of the Base Lease Term of the Lease discounted to present value at ten percent (10%) per annum, it being acknowledged and agreed that actual damages under such circumstances would be impossible or difficult to determine.

The AAR court did not establish in the record whether or not AAR had an obligation to mitigate VH's damages by crediting it for a subsequent disposition of the aircraft. What the record does establish however is that AAR did in fact subsequently re-lease the aircraft to a third party and correspondingly reduced its claim for future rents owed by VH by the amount of rent it obtained (or was to obtain) from the new lessee.

The net result was that AAR lost its claim for liquidated damages. What is concerning for many lessors is that by the time the case wound its way through the court system, AAR, as the aggrieved lessor, acted as most prudent leasing companies would expect ' it repossessed its aircraft from VH, re-leased the aircraft to a third party and demanded that VH pay an amount equal to past due rent, plus the present value of the future rent that would have become due had the Lease gone full term (discounted at 10% per annum ' we'll set aside our thoughts about why anyone in the last 90s would agree to such a high discount rate). Moreover, although not required by the negotiated terms of the Lease, AAR credited for the account of VH the amount of rent for which it contracted with the new lessee. Despite adhering to what seemed to be very reasonable terms from a negotiated commercial contract between two sophisticated parties, the AAR court held that such a provision was nothing more than an unenforceable penalty imposed by AAR.

In justifying its decision in holding the liquidated damages provision as an unenforceable penalty, the ARR court noted:

Where a contract provides that a breaching party must pay all damages caused by the breach as well as a specified sum in addition thereto, the sum so specified can be nothing but security for performance and, therefore, constitutes an unenforceable penalty … AAR's liquidated damage provision does not credit the defendants with the difference between the estimated residual value at the end of the lease term and the obviously greater value of the aircraft when it was repossessed.

So, the AAR court seems to have concluded that any lease which provides for both actual damages and liquidated damages is per se unenforceable without regard as to whether a “double-dipping” by the lessor has occurred (that is, whether the lessor in question actually attempted to recover both actual damages and liquidated damages ' it is not clear whether ARR tried this) and that lessors have an absolute responsibility to credit lessees with the value of the assets repossessed as of the day of such repossession as opposed to its estimated value at the end of the lease term. In other words, it is not simply enough to discount the value of the remaining future rentals. Rather, lessors also must credit the lessee for the higher value of the asset as of the day it is repossessed or returned against its (likely) lower value at the end of the lease term.

The concern is that the AAR decision may be viewed as an erosion of the rights established in favor of lessors under Article 2A of the UCC. The drafters of UCC Article 2A attempted to lessen the confusion created by the patchwork quilt of cases and legal theories that surrounded equipment leasing in general and liquidated damages, in particular prior to its enactment. The importance of liquidated damages provisions to modern leasing practices is explained in the Official Comment to 2A-504 which notes that “many leasing transactions are predicated on the parties' ability to agree to an appropriate amount of damages or formula for damages in the event of a default. … ” Such a statutory recognition of the parties' right to contractually set damages is consistent with the underlying theme of UCC Article 2A, specifically freedom of contract between sophisticated parties entering into sophisticated transactions. Accordingly, 2A-504(1) states that parties to a lease can agree to liquidated damages, provided that the amount of liquidated damages, or the formula used to calculate the amount, is “ reasonable in light of the then anticipated harm caused by the default. … ”

Other provisions of Article 2A shed further light on what should be deemed to be a reasonable formula for calculating damages. Section 2A 528-1 provides for payment by the lessee, once the leased asset has been repossessed, of the present value of the remaining rents less the present value of the “market rent at the place where the goods are located” for the remainder of the lease term. No offset for market rent is necessary if either the leased asset is neither repossessed by the lessor or tendered by the lessee or, after “reasonable effort,” the lessor is unable to dispose of the asset. In addition, Section 2A-531 provides that, in addition, a lessor may recover an amount that will “fully compensate” it for the loss of, or damage to, lessor's residual interest in the aircraft. It is important to note that Article 2A does not specify that the lessor must also credit for the residual value upside caused by the default as the AAR court suggests.

So, with such a statutory right, when are liquidated damages provisions not enforceable? Section 2A-504 expressly permits liquidated damages as a lease remedy if they are “reasonable in light of the then anticipated harm caused by the default.” It is important to note that the UCC, unlike the common law in most states, does not impose any additional requirement on a lessor that the injury caused by the breach must be difficult or impossible to calculate. The Official Comment to Section 2A-504 makes clear that this omission was intentional and should not be applied (although certainly more than one court has done so). There are a growing number of cases (such as AAR) that have analyzed liquidated damages under Article 2A. The pre-Article 2A general common law rule is that a liquidated damage provision is an unenforceable penalty unless it bears some reasonable relationship to probable damages and unless actual damages are difficult to ascertain. A liquidated damage clause purporting to require the lessee to pay all future rentals without reduction is likely to be held to constitute a penalty. This is because the lessor would be getting a double recovery if it receives both the asset and future rent. Additionally, if the lessor receives the rent without discounting to present value, a windfall occurs once the lessor reinvests those monies. Also (and as seems to be the situation in AAR), common law looks unfavorably at remedies clauses that do not provide an offset for the present value of the repossessed asset ' unless it is clear that such asset is usable only in the original lease to the original lessee.

In cases that considered the enforceability of liquidated damages provisions that included not only discounted, accelerated rents, but also the discounted end-of-term residual value, the courts upheld the clause in question. Where, like AAR, the lessor did not discount the end-of-term residual, the liquidated damage provision was held to constitute an unenforceable penalty.

So, as is often the case, courts have taken the framework provided by a statutory right and expanded it to apply to real-world, pragmatics ' what the market demands and/or expects.

The practical application of the current case law suggests a number of drafting strategies. First, any formula should generally track 1) the discounted full-term rentals, 2) the discounted anticipated end of term residual value, plus 3) the loss of anticipated tax benefits. Second, the rent acceleration provision should be discounted to present value using a reasonable discount rate. Third, the lessee should be given a credit for disposition proceeds (with consideration for the sufficiency of such credit). Finally, in all cases, if the lessor is likely to receive a windfall by demanding liquidated damages, it should be concerned about the vulnerability of the remedy.

Another strategy for drafting is to include in your leases liquidated damages provisions that track 2A-527 (if the equipment is re-leased pursuant to a substantially similar lease), 2A-528 (if the equipment is not re-leased pursuant to a substantially similar lease) and 2A-529 (if the equipment is not disposed of by lessor).

Whatever the lessor chooses as its preferred liquidated damages provision, it always must be remembered that such clauses are intended to give the lessor the benefit of its bargain ' nothing less, but certainly, nothing more. And, as the AAR decision and other cases demonstrate, courts are not bashful about flexing their muscle in striking down such clauses when they feel that the lessor is overreaching.

A recent court decision striking down the liquidated damages provision of an aircraft lease should cause lessors to rethink (and possibly redraft), their standard remedies clauses.

In AAR International, Incorporated v. Nimelias Enterprises S.A., Vacances Heliades S.A. and Princess Airlines S.A., 2004 WL 2966659 (N.D. ILL.), No. 99 C 8090 (Dec. 1, 2004), the U.S. District Court for the Northern District of Illinois, applying Illinois law, declared the lessor's liquidated damages clause in an aircraft lease as an unenforceable penalty since such calculation both: 1) permitted spontaneous recovery by lessor of both actual and liquidated damages, and 2) did not take into account the early recapture of the leased aircraft and credit lessee with the difference between the estimated residual value at the end of the lease term and the greater value of the aircraft when it was repossessed.

Whether viewed as an anomaly or not, the AAR decision should serve as a warning to lessors (as well as investors purchasing or taking collateral assignments of leases) to pay special attention to the way their remedy provisions are drafted so as to avoid the unfortunate outcome that befell AAR International, Incorporated (“AAR”).

The AAR decision highlights how courts continue to struggle with interpreting UCC Article 2A's remedy provisions and emphasizes the delicate balance drawn between crafting a liquidated damage provision that affords the lessor the benefit of its bargain and one that will be struck down as an unenforceable penalty.

The underlying facts of the AAR case are fairly common. In May 1998, AAR, as lessor, entered into an Aircraft Lease Agreement (the “Lease”) with Vanances Heliades S.A., as lessee (“VH”) for a term of 96 months covering a Boeing 737 aircraft. The Lease had a fixed monthly rent component of $275,000 per month. VH in turn subleased the aircraft to Nimelias Enterprises S.A. (“NE”), which in turned sub-subleased it to Princess Airlines. Both the sublease and sub-sublease arrangements were known to AAR with each of VH and NE assigning all of their rights, title and interest under the sublease and sub-sublease, respectively, to AAR. Only several months after the commencement of the Lease, AAR alleged that VH was in default of the Lease for various reasons including VH's failure to make timely payments, the existence of unpermitted liens on the aircraft and VH's failure to maintain the aircraft in accordance with the terms of the Lease (among others). As a result of these breaches, AAR cancelled the Lease in September 1999 and sought to exercise its cumulative remedies ' including repossessing the aircraft and seeking payment of liquidated damages as stipulated in the Lease.

The pertinent part of the liquidated damages provision of the Lease that the AAR court examined reads as follows:

Whether or not Lessor shall have exercised or shall at any time thereafter exercise any of its rights [to repossesses the aircraft], Lessor by written notice to Lessee specifying a payment date not earlier than five (5) days from the date of such notice, may demand that Lessee pay Lessor, and Lessee shall pay Lessor, in addition to such other remedies, as liquidated damages for loss of a bargain and not as a penalty, an amount equal to Base Rental, Variable Rental, and other charges unpaid as of the date of such notice, plus an amount equal to the entire Base Rental for the duration of the unexpired period remaining of the Base Lease Term of the Lease discounted to present value at ten percent (10%) per annum, it being acknowledged and agreed that actual damages under such circumstances would be impossible or difficult to determine.

The AAR court did not establish in the record whether or not AAR had an obligation to mitigate VH's damages by crediting it for a subsequent disposition of the aircraft. What the record does establish however is that AAR did in fact subsequently re-lease the aircraft to a third party and correspondingly reduced its claim for future rents owed by VH by the amount of rent it obtained (or was to obtain) from the new lessee.

The net result was that AAR lost its claim for liquidated damages. What is concerning for many lessors is that by the time the case wound its way through the court system, AAR, as the aggrieved lessor, acted as most prudent leasing companies would expect ' it repossessed its aircraft from VH, re-leased the aircraft to a third party and demanded that VH pay an amount equal to past due rent, plus the present value of the future rent that would have become due had the Lease gone full term (discounted at 10% per annum ' we'll set aside our thoughts about why anyone in the last 90s would agree to such a high discount rate). Moreover, although not required by the negotiated terms of the Lease, AAR credited for the account of VH the amount of rent for which it contracted with the new lessee. Despite adhering to what seemed to be very reasonable terms from a negotiated commercial contract between two sophisticated parties, the AAR court held that such a provision was nothing more than an unenforceable penalty imposed by AAR.

In justifying its decision in holding the liquidated damages provision as an unenforceable penalty, the ARR court noted:

Where a contract provides that a breaching party must pay all damages caused by the breach as well as a specified sum in addition thereto, the sum so specified can be nothing but security for performance and, therefore, constitutes an unenforceable penalty … AAR's liquidated damage provision does not credit the defendants with the difference between the estimated residual value at the end of the lease term and the obviously greater value of the aircraft when it was repossessed.

So, the AAR court seems to have concluded that any lease which provides for both actual damages and liquidated damages is per se unenforceable without regard as to whether a “double-dipping” by the lessor has occurred (that is, whether the lessor in question actually attempted to recover both actual damages and liquidated damages ' it is not clear whether ARR tried this) and that lessors have an absolute responsibility to credit lessees with the value of the assets repossessed as of the day of such repossession as opposed to its estimated value at the end of the lease term. In other words, it is not simply enough to discount the value of the remaining future rentals. Rather, lessors also must credit the lessee for the higher value of the asset as of the day it is repossessed or returned against its (likely) lower value at the end of the lease term.

The concern is that the AAR decision may be viewed as an erosion of the rights established in favor of lessors under Article 2A of the UCC. The drafters of UCC Article 2A attempted to lessen the confusion created by the patchwork quilt of cases and legal theories that surrounded equipment leasing in general and liquidated damages, in particular prior to its enactment. The importance of liquidated damages provisions to modern leasing practices is explained in the Official Comment to 2A-504 which notes that “many leasing transactions are predicated on the parties' ability to agree to an appropriate amount of damages or formula for damages in the event of a default. … ” Such a statutory recognition of the parties' right to contractually set damages is consistent with the underlying theme of UCC Article 2A, specifically freedom of contract between sophisticated parties entering into sophisticated transactions. Accordingly, 2A-504(1) states that parties to a lease can agree to liquidated damages, provided that the amount of liquidated damages, or the formula used to calculate the amount, is “ reasonable in light of the then anticipated harm caused by the default. … ”

Other provisions of Article 2A shed further light on what should be deemed to be a reasonable formula for calculating damages. Section 2A 528-1 provides for payment by the lessee, once the leased asset has been repossessed, of the present value of the remaining rents less the present value of the “market rent at the place where the goods are located” for the remainder of the lease term. No offset for market rent is necessary if either the leased asset is neither repossessed by the lessor or tendered by the lessee or, after “reasonable effort,” the lessor is unable to dispose of the asset. In addition, Section 2A-531 provides that, in addition, a lessor may recover an amount that will “fully compensate” it for the loss of, or damage to, lessor's residual interest in the aircraft. It is important to note that Article 2A does not specify that the lessor must also credit for the residual value upside caused by the default as the AAR court suggests.

So, with such a statutory right, when are liquidated damages provisions not enforceable? Section 2A-504 expressly permits liquidated damages as a lease remedy if they are “reasonable in light of the then anticipated harm caused by the default.” It is important to note that the UCC, unlike the common law in most states, does not impose any additional requirement on a lessor that the injury caused by the breach must be difficult or impossible to calculate. The Official Comment to Section 2A-504 makes clear that this omission was intentional and should not be applied (although certainly more than one court has done so). There are a growing number of cases (such as AAR) that have analyzed liquidated damages under Article 2A. The pre-Article 2A general common law rule is that a liquidated damage provision is an unenforceable penalty unless it bears some reasonable relationship to probable damages and unless actual damages are difficult to ascertain. A liquidated damage clause purporting to require the lessee to pay all future rentals without reduction is likely to be held to constitute a penalty. This is because the lessor would be getting a double recovery if it receives both the asset and future rent. Additionally, if the lessor receives the rent without discounting to present value, a windfall occurs once the lessor reinvests those monies. Also (and as seems to be the situation in AAR), common law looks unfavorably at remedies clauses that do not provide an offset for the present value of the repossessed asset ' unless it is clear that such asset is usable only in the original lease to the original lessee.

In cases that considered the enforceability of liquidated damages provisions that included not only discounted, accelerated rents, but also the discounted end-of-term residual value, the courts upheld the clause in question. Where, like AAR, the lessor did not discount the end-of-term residual, the liquidated damage provision was held to constitute an unenforceable penalty.

So, as is often the case, courts have taken the framework provided by a statutory right and expanded it to apply to real-world, pragmatics ' what the market demands and/or expects.

The practical application of the current case law suggests a number of drafting strategies. First, any formula should generally track 1) the discounted full-term rentals, 2) the discounted anticipated end of term residual value, plus 3) the loss of anticipated tax benefits. Second, the rent acceleration provision should be discounted to present value using a reasonable discount rate. Third, the lessee should be given a credit for disposition proceeds (with consideration for the sufficiency of such credit). Finally, in all cases, if the lessor is likely to receive a windfall by demanding liquidated damages, it should be concerned about the vulnerability of the remedy.

Another strategy for drafting is to include in your leases liquidated damages provisions that track 2A-527 (if the equipment is re-leased pursuant to a substantially similar lease), 2A-528 (if the equipment is not re-leased pursuant to a substantially similar lease) and 2A-529 (if the equipment is not disposed of by lessor).

Whatever the lessor chooses as its preferred liquidated damages provision, it always must be remembered that such clauses are intended to give the lessor the benefit of its bargain ' nothing less, but certainly, nothing more. And, as the AAR decision and other cases demonstrate, courts are not bashful about flexing their muscle in striking down such clauses when they feel that the lessor is overreaching.