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Lessors Beware of the Enforceability of Stipulated Loss Value Tables

February 16, 2018, 07:00 AM

A recent ruling by a judge in the influential Bankruptcy Court for the District of Delaware may indicate that Stipulated Loss Value tables are more at risk than is commonly believed in the industry.

The opinion arose in a Chapter 11 bankruptcy case filed by Tidewater Inc. and its affiliated debtors (the “Tidewater Debtors”), entities that own and operate “Offshore Support Vessels” that support energy exploration and production activities. In 2013 and 2014, prior to the bankruptcy filings, certain of the Tidewater Debtors sold ships to six different bank-lessors which banks subsequently leased the ships back to the Tidewater Debtors pursuant to sale-leaseback agreements. Those agreements, referred to as “bareboat charter agreements,” are a type of charter agreement that governs the terms and conditions for the lease of a vessel. The agreements expressly provided that upon an event of default (as defined in the agreements), the lessors would be entitled to recover from the lessees a stipulated loss value (“SLV”) as liquidated damages. The SLVs were set forth in a table contained within each agreement. As part of the consideration for each lessor to enter into the sale-leaseback transaction, Tidewater Inc. guaranteed absolutely and unconditionally the payment and performance of the obligations of the lessees under the agreements.

The Tidewater Debtors’ subsequent rejection of the agreements under Section 365(a) of the Bankruptcy Code constituted an event of default under the agreements. Accordingly, the bank-lessors sought summary judgment determining the Tidewater Debtors’ liability (and therefore Tidewater Inc.’s liability as guarantor) in the amounts set forth in the SLV table. The bank-lessors asserted that the SLV provisions were enforceable because they allowed them to get the benefit of their bargain, irrespective of market conditions, and that because the actual damages exceeded the SLV, the SLV was not a windfall. The Tidewater Debtors opposed the motion on the basis that the SLVs were penal in nature and bore no relationship to the bank-lessors’ actual damages, and also cross-moved for summary judgment on their own calculation of the liability, which was based on the total maximum amount owed under each bareboat charter agreement discounted to present value. The Tidewater Debtors argued that liability should be limited to “the reasonable expectation damages” of the lessors. The difference between the value asserted by the bank-lessors and the value asserted by the Tidewater Debtors was dramatic – approximately $60 million.

Judge Brendan Shannon, in an oral opinion, sided with the Tidewater Debtors by rejecting the SLVs. Relying on prior federal case law in the Third Circuit, he found that the SLVs constituted penalty provisions, and were therefore unenforceable as a matter of public policy. Significantly, Judge Shannon found that section 2A-504 of the Uniform Commercial Code (“UCC”) (generally approving the use of liquidated damages provisions in lease agreements and expressly blessing common industry provisions such as SLV’s so long as they are reasonable in light of the harm anticipated when the formula was agreed to) did not abrogate the Third Circuit Court of Appeals’ decision in In re T.W.A. Airlines, Inc., 145 F.3d 124 (3d Cir. 1998), which reviewed the enforceability of a liquidated damages provision in a lease that was executed prior to the adoption of section 2A-504 of the UCC and held the provision unenforceable under New York state law (which also applied in the Tidewater case). The court also cited favorably the Third Circuit’s opinion in In re Montgomery Ward Holding Corp., 326 F.3d 383 (3d Cir. 2003), which applied Illinois law and similarly held that a liquidated damages provision was unenforceable despite the blessing of reasonable industry liquidated damages provisions in commercial leases (including SLVs) in the Official Comment to section 2A-504.

Notably, the court declined to rule on the bank-lessors’ alternative argument – that Tidewater Inc., as guarantor, was still liable for the SLVs even if they were unenforceable against the primary lessees because the absolute and unconditional nature of the guaranties eliminated the defense that the SLVs were penal in relation to any guarantor. Unfortunately, the bank-lessors settled their claims with the Tidewater Debtors before the hearing scheduled to resolve this outstanding question. Accordingly, how the Bankruptcy Court for the District of Delaware might rule on the guarantor’s liability – which was one of “first impression” for the court – remains an open question. However, at least one other court that has reviewed the issue under New York law found that a guarantee precluded a guarantor from objecting to the damages set forth in a liquidated damages provision, even where the court found that such provision was a penalty. See 136 Field Point Circle Holding Co., LLC v. Invar Int’l Holding Co., 644 Fed. Appx. 10 (2d Cir. 2016).
The takeaway from the Tidewater case is that lessors cannot always rely on the enforceability of stipulated loss value tables in lease agreements, especially where the actual damages incurred from the rejection of the agreements at issue are significantly less than the liquidated damages specified in the stipulated loss value tables. Particularly in the bankruptcy courts, where judges are empowered to make decisions based on equitable considerations, contractually agreed-to liquidated damages provisions may be at risk. In this case, the court’s opinion makes clear that, despite the clearly expressed intent of the drafters of Article 2A that commonly used liquidated damages clauses in the industry (including SLVs) would be upheld so long as they were reasonable (see U.C.C. § 2A-504 and Comments 1, 3 to § 2A-504), and that freedom of contract was a significant governing principal of that article, public policy considerations and state law may trump even SLVs that were bargained for between sophisticated commercial entities. Although the court’s opinion could arguably be distinguishable on the basis that it was concerned specifically with bareboat charter agreements, the judge’s analysis and ruling were sufficiently broad as to potentially be highly persuasive in future disputes involving SLVs (or other similar liquidated damages provisions) contained in other types of lease agreements (sale-leaseback or otherwise).

While there is no silver bullet to ensure liquidated damages provisions are always enforced, a lessor can take certain steps at the outset of the transaction to help protect such provisions from challenges by a debtor/lessee and minimize the possibility that a Court will reject the provision as unenforceable. Among other things, the lessor should attempt to structure an SLV (or similar liquidated damages provision) to facilitate the argument that, at the time of contracting, the amount bore a reasonable and rational relationship to the expected loss. The parties should also expressly acknowledge that the actual damages in the event of a future default cannot be predicted with any certainty, that the SLV represents a reasonable estimate of damages in the event of a future default, and that the amount contemplated is not a penalty. Another important consideration is the choice of law provision in the lease agreement. As recognized in both Tidewater and T.W.A., state law ultimately governs the enforceability of liquidated damages provisions and some states treat liquidated damages provisions more favorably than others. Additionally, because state law also dictates the enforceability of absolute guarantees, the lessor should consider choosing law from those states, like New York, that may give full force to guarantees even where liquidated damages provisions are deemed a penalty.

In sum, in the wake of Tidewater lessors must be more prepared for objections by debtors to SLV tables and should consider reviewing and revising future liquidated damages and related provisions to maximize the likelihood of withstanding judicial review.

Photos of Robert L. Hornby and Ryan O’Connor, Esq. and Frank Peretore, Esq.

Frank Peretore, Robert L. Hornby & Ryan O’Connor
Chiesa Shahinian & Giantomasi PC
Frank Peretore, Esq., member and Co-Chair of Chiesa Shahinian & Giantomasi PC’s Equipment Leasing and Financing Group, has over 30 years’ experience representing equipment lessors and asset based lenders. He represents national and regional finance companies and banks ranging from closely held companies to Fortune 100 companies. Peretore’s representation includes the negotiation and drafting of loan/lease documentation and the purchase/sale of individual transactions and full portfolios as well as the enforcement of lessors’ and secured creditors’ rights in thousands of matters in the state, federal, and bankruptcy courts. As a long-standing leader in his field, Peretore has published two highly-acclaimed books titled “Secured Transactions for the Practitioner: How to Properly Perfect Your Personal Property Lien and Assure Priority” (2018 Edition) and “Workouts and Enforcement for the Secured Creditor and Equipment Lessor” (LexisNexis 2015 Edition). Peretore received his law degree from Georgetown University Law Center.

Robert L. Hornby, Esq. is Co-Chair of Chiesa Shahinian & Giantomasi PC’s Equipment Leasing and Financing Group. An experienced litigator, Hornby represents national and regional banks and finance companies in all aspects of equipment leasing, asset based lending and civil litigation in New York and New Jersey state and federal courts. Hornby regularly counsels clients on a wide range of matters unique to the equipment leasing and finance industry, including drafting master documentation, enforcement of secured creditors’ rights and lien priority. He also counsels clients regarding their compliance with state and federal cybersecurity laws and regulations. Hornby recently co-authored the 2018 Edition of “Secured Transactions for the Practitioner: How to Properly Perfect Your Personal Property Lien and Assure Priority.” Hornby received his law degree cum laude from Seton Hall University School of Law, and his undergraduate degree cum laude from the University of Arizona. He served as a Judicial Law Clerk for the Honorable David S. Baime, PJAD (ret.) in the New Jersey Appellate Division.

Ryan O’Connor, Esq. is an associate in the firm’s Equipment Leasing and Financing and Bankruptcy and Creditors' Rights groups. He has assisted in the advising and representing of creditors, predominantly lenders in the equipment finance and leasing sector, in connection with litigation both inside and outside of bankruptcy. Prior
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