Equipment Lessors Can Survive Liquidated Damage Attacks

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Lquidated damages are a common, albeit not always mforced, remedy in personal-property leases. Many leases provide for the recovery of "casualty value," "stipulated loss value" or "anticipated residual

value" amounts from defaulting lessees. Despite the "favored" status of liquidated damage provisions under Article 2A of the Uniform Commercial Code, lessors have met with mixed results in convincing the courts to enforce these types of liquidated damage provisions. However, knowledge of the critical facts, coupled with an understanding of the law, can maximize the probability that such provisions will be enforced.

Statutory background

Section 2A-504 of the Uniform Commercial Code (UCC) governs the ability of parties to liquidate damages' in personal-property lease transactions. Article 2A was specifically intended to provide leasing parties with the maximum possible freedom to agree to reasonable liquidated damage provisions. Even the Code Comments make it clear that the parties are "invited" to liquidate damages.2

UCC 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-anticipated harm caused by the default or other act of omission." Article 2A clearly envisions the use of formulas such as casualty values, stipulated loss values or anticipated residual values. In fact, the Code Comments to UCC 2A-504 highlight liquidated damage provisions commonly used in the industry.

In commercial transactions, UCC 2A-504 has dispensed with the traditional requirement that liquidated damages are enforceable only if the loss is difficult to prove and alternative remedies would be inconvenient or infeasible. The Article 2A drafters recognized that the ability to liquidate damages is critical to modern leasing practice and made it easier to enforce such provisions through the deletion of these otherwise sometimes difficult-to-cstablish requirements.3

To further underscore the "invitation" to liquidate damages, the drafters of UCC 2A-504 specifically chose not to incorporate the last sentence of the liquidated damage provisions applicable to sales under Article 2. UCC 2-718 provides that "a term fixing unreasonably large liquidated damages is void as a penalty." The drafters omitted this sentence from UCC 2A-504 in order to enable the parties to liquidate the amount payable associated with indemnity for loss or diminution of anticipated tax benefits, as contemplated in UCC 2A-504(a). The drafters were clearly aware of the potentially significant impact of local, state and federal tax laws on leasing transactions.4 In addition, the official Code Comments to UCC 2A-504 specifically refer to depreciation allocations as a factor which can justify a liquidated damage amount or formula.

In summary, Article 2A makes clear that "liquidated damages" are not a nefarious concept in personal-property lease transactions. On the contrary, they are a vital, necessary and legitimate remedy which the parties are free to negotiate, restrained only by the rule of reasonableness.

Case law developments

Courts have clearly recognized that leasing transactions are an ever-increasing segment of commercial activity.5 However, there is only a limited body of case law which has applied and interpreted liquidated damage provisions in personal-property leases. Nevertheless, unmistakable general principles as well as specific fact patterns can be identified which can be used to support or attack the reasonableness of liquidated damage provisions, even though each case must be decided on its own facts.

The courts have provided flesh and bones to Article 2A in many procedural and substantive respects. For example, it is clear that including a provision acknowledging that the liquidated damage provision is reasonable and not a penalty is unlikely to succeed. Courts typically ignore the tyranny of labels.6 Similarly, contractual recitations highlighting the arm's-length nature of the commercial negotiations are probably also unavailing, although at least one court has noted that such equal bargaining power can serve as "additional support" to uphold an otherwise reasonable liquidated damage provision.7

The courts have also provided some procedural litigation guidance. It is the lessee's burden to demonstrate that the liquidated damage provision is unreasonable.8 Whether a clause is an enforceable liquidated damage provision is a question oflaw for the court, not the jury.9 Moreover, summary judgment remains possible, even though a reasonableness test is involved.10

Several courts have reaffirmed the Article 2A preference for liquidated damages and have suggested judicial circumspection. Judges should keep in mind that liquidated damage provisions were negotiated by parties who are familiar with the circumstances and practices of the transactions involved, and that these provisions carry with them a consensual apportionment of transactional risk that a court should be slow to overturn.11

Moreover, the courts have clarified that the liquidated damage provision must be evaluated at the time the contract was signed, as opposed to at the time of default.12 No court should strike down a liquidated damage provision based on foresight that has proved in hindsight to have contained an inaccurate estimation of probable loss. The fact that there is a difference between the actual loss at the time ofdefault and the anticipated loss at the time of contracting does not necessarily mean that the liquidated damages clause is unenforceable."Thus, the courts should not substitute their own judgment for the parties' agreed-upon liquidated damages, which agreement should be upheld unless the provision is unreasonable in light of the harm anticipated at signing.14

Several reported decisions have also helped to define the parameters of the reasonableness test. No bright line test exists, but definite trends have emerged.

Many courts have viewed the reasonableness test in terms of whether the liquidated damages amount represents a reasonable forecast of the probable loss.'Others have focused on whether the remedy places the lessor in roughly the same position it would have been in had the default not occurred.16

Liquidated damage provisions which allow the recovery of future rent are routinely found enforceable, especially where the future rent is discounted to present value and the lessor provides a credit lor the disposition (by sale or re-leasing) of the property.17 However, at least one court has implied that recovery of future rents, without discounting, would be unreasonable. The court was willing to imply a discount rate, however.18 Failing to provide a credit for the resale or re-letting, while simultaneously seeking to recover the future rentals, has been found to be an unenforceable penalty in at least one instance.19

Taking it a step further, courts have also found reasonable a liquidated damage provision which entitled the lessor to unpaid rents, to future rents discounted to present value, and the anticipated residual value of the equipment, so long as the lessee receives a credit for the net proceeds reali/ed from the disposition of the equipment.20 Discounting the anticipated residual value seems to have made the analysis easier, although at least one other court did not specifically require that the estimated residual value be discounted.21 Even liquidated damage provisions in consumer lease cases have been found reasonable, as long as the residual and the future rents are properly discounted.22

On the other hand, another case that was eventually decided on other grounds provides a cautionary lesson on overreaching. One court found unenforceable a liquidated damage provision which permitted the lessor to recover the unpaid rents, the future rents and (he present value of the anticipated residual value." The provision even afforded the lessee a credit for any re-letting proceeds. However, the court found the provision unreasonable because the literal terms of the lease did not provide the lessee with any credit for sale (as opposed to lease) proceeds, thereby potentially providing the lessor with a possible double recovery. Significantly, the court was not influenced by the fact that, in practice, the lessor actually did provide the lessee with the sale credit. Instead, the court focused on the contract "as written," as opposed to how it was employed. Other courts have taken a less draconian approach.24

In analyzing casualty value provisions, the courts have carefully scrutinized how the formula was calculated. A casualty value fixed at three times the amount of the unpaid future rentals was found to be unenforceable, since the total damages proved to be far in excess of the failmarket value of the equipment.-' In that case, the lessor wanted the court to consider the lessor's likely profit arising out ol'the likely, but not assured, end-of-term sale or lease of the equipment to its lessee. However, the court refused to do so since, the lessor submitted evidence of its historical ability to sell or re-lease to its lessees, at a profit or otherwise. This court also had trouble with the concept that the lessee was entitled to credit for sale or re-letting only to the extent those credits exceeded the casualty value which, by definition, was virtually never.

Another court refused to enforce a liquidated damage provision, where the casualty value calculation would have enabled the lessor to recover large profits, even though no profits would have been earned had the lessee performed under the lease as agreed.26 The court took particular note of the leveraged lease structure, finding that the lessor has deliberately chosen a lease-pricing structure which enabled it to offer lower rental rates. Since there were no assurances that the lessee would purchase or continue to lease the property, the liquidated damage provision which assumed the back-end profit was deemed unreasonable, since it placed the lessor in much better position than it would have been had the lessee performed as agreed. In short, the lessor gambled on the future and lost, and the court refused to shift the risk ofthat loss to the lessee through the liquidated damage provision.

The same court also questioned the reasonableness of a casualty value schedule that could lead to radically different liquidated damage amounts depending on the date of the breach. The court noted in that regard that damages "should not be invariant to the gravity of the breach." The court further noted that a clause which is merely designed to provide the in terrorem effect of compelling performance smacked of an unenforceable penalty.

Another court recently found a liquidated damage provision based on casualty values to be enforceable, even though it might result in a payment of four or five times the fair market value of the equipment.27 The court noted that end-of-term value of the subject computer equipment was speculative, rendering the up-front casualty determination a reasonable forecast of difficult-lo-ascertain damages. The court was mindful of the fact that the lease provision was negotiated by two sophisticated international companies.

Yet another way to calculate stipulated loss value is to use a set percentage of the lessor's capitalized cost/" One court held that 20 percent of the lessor's capitalized cost resulted in an enforceable, stipulated, value-based provision under the facts ofthat case. Actual depreciation issues are also a relevant factor.29

One component of many liquidated formulas is an estimate of fair-market rental value or estimated fair-market value. One court entered summary judgment, even though the defaulting lessee was entitled to a fair-market value set-off to reduce the amount of the damages.30 The subject lease permitted the lessor to determine the value by a single appraiser of the lessor's choosing. The court found this provision reasonable and specifically noted that the very reason for the bargained-for provision, permitting the lessor to choose the appraiser, was to avoid the necessity for lengthy judicial proceedings over this component ofthe formula.

Conclusions

Despite the nominally favored status of liquidated damage provisions under UCC 2A-504, many courts seem reluctant to discard the notion that liquidated damage provisions are nefarious and should be viewed with distrust. To combat any undue prejudice, the lessor should be prepared to point out that the statutes and Code Comments amply demonstrate that the law invites commercial-equipment leasing parties to liquidate damages. The nationwide case law can also be employed to overcome undue prejudice.

Tax indemnity, depreciation, lost profits, lessor reliance on resale or re-letting to lessees, the use of statutorily-approved formulas and any other factors should be considered in establishing reasonableness. The retention of expert witnesses might also make sense.

When drafting leases, consideration should be given to ensuring that defaulting lessees are given the benefit of discounting to present value. Future rentals and anticipated residual value calculations are readily amenable to discounting. The lessor should also consider triggering the liquidated damages provision only upon the occurrence of major events of default. Moreover, ensuring that casualty value, stipulated loss value or anticipated residual value formulas or tables are made available to lessees at the time of contracting can also heighten the sense of reasonableness by avoiding a claim of surprise. Lastly, it is also worthwhile to consider establishing by contract the procedures for determining discretionary elements such as fair-market rental value.

Liquidated damage provisions can function as much more than a hammer to compel performance by lessees. Properly employed, such provisions can fulfill their rightful place in modern equipment-leasing practice as fully enforceable, contractually binding remedy provisions.

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..."liquidated damages" are not a nefarious concept in personal-property lease transactions.

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...the courts have carefully scrutinized how the formula was calculated.

FOOTNOTE

Endnotes

1 The reader is reminded that not every state has enacted the model Article 2A exactly as drafted. The statutes of the governing state are controlling.

2 UCC 2A-504, Uniform Commercial Code Comment.

3 UCC 2A-504, Uniform Commercial Code Comment.

4 UCC 2A-504, Uniform Commercial Code Comment.

5 Coastal Leasing Corporation v. T-Barr S. Corporation, etc., 128 N.C.App. 379, 496 S.E. 2d 795 (1998).

6 In Re Montgomery Ward Holding Corp., etc. v. Meridian Leasing Corporation, 326 F.3d 383 (3d Cir. 2003).

7 Coastal Leasing Corporation, supra.

8 Sun v. Mercedes Benz Credit Corporation, 254 Ga.App. 463, 562 S.E.2d 714 (2002).

9 Id.; Carter v. Tokai Financial Services, Inc., 231 Ga.App. 755 (1998).

10 Coastal Leasing Corporation, supra; Sun, supra; Jamsky v. HPSC, Inc., 238 Ga.App. 477, 519 S.E.2d 246 (1999).

11 Coastal Leasing Corporation, supra.

12 In Re Montgomery Ward Holding Company, supra; In Re Baldwin Rentals: Case Credit Corporation v. Baldwin Rental Centers, Inc., 228 B.R. 504 (S.D. Ga. 1998).

13 Coastal Leasing Corporation, supra.

14 Eplus Group, Inc., etc. v. Panoramic Communications LLC, etc., 50 U.C.C. Rep.Serv.2d 213 (SDNY 2003).

15 Coastal Leasing Corporation, supra; In Re Montgomery Ward Holding Company, supra.

16 Eplus Group, Inc., supra.

17 See In Re Baldwin Rental Centers, Inc., supra; Wells Fargo Bank Northwest v. Taca International Airlines, 50 U.C.C. Rep.Serv.2d 811 (SDNY 2003). See also Siletz Trucking Co. v. Alaska International Trading Co., 467 F.2d 961 (9th Cir, 1972).

18 Frontier Leasing Corporation v. Griffin Petroleum, Inc., 172 F.Supp.2d 1172 (S.D.la. 2001 ).

19 Carter, supra.

20 Jamsky, supra; see also In Re: James Edward Snelson, 305 B.R. 255 (Bank ND. Tx 2003).

21 Sun, supra.

22 Alberto Torres v. Banc One Leasing Corporation, 226 F.Supp.2d 1345 (N.D. Ga. 2002).

23 Atel Financial Corporation v. Quaker Coal Company, 132 F.Supp.2d 1233 (N.D. Cal. 2001) (affirmed on other grounds 2003 U.S. App. Lexis 3867 (9th Cir. 2003)).

24 Sun, supra.

25 Eplus, supra.

26 In Re Montgomery Ward Holding Company, supra.

27 Winthrop Resouces Corporation v. Eaton Hydraulics, Inc., 361 F.3d. 465 (8th Cir. 2004).

28 In Re D&S Electrical/Mechanical Co., Inc., 297 B.R. 805 (Bank N.D. Ala. 2003).

29 Alberto Torres, supra.

30 Wells Fargo Bank Northwest, supra.

IMAGE PHOTOGRAPH 4AUTHOR_AFFILIATION

Mark M. Scott, Esq., is a shareholder in Buchalter, Nemer, Fields & Younger, Irvine, CA. His practice includes the representation of financial institutions in commercial and general business litigation.