Two Recent Cases Shed Light on Liquidated Damages

Virtually every equipment financing contract (lease or mortgage) provides a fixed claim for damages (liquidated damages) payable by the Obligor (lessee or mortgagor) upon a breach of such contract.  While the concept of liquidated damages is relatively straightforward, there is a long and complicated history of litigation regarding the enforceability of claims for liquidated damages, as two recent cases demonstrate.  Liquidated damages are damages agreed to by the parties to a contract at the time of contract formation which establish a formula or predetermined sum that must be paid upon a specific breach.  Liquidated-damages clauses are common in contracts, as they provide for greater predictability of damages payments in the event one party does not fulfill its contractual obligations.  While contracting parties are free to agree to the payment of liquidated damages, such provisions are not always enforceable.  In determining whether a liquidated-damages provision is enforceable, there are a number of factors courts will consider.  Primarily, courts will look to whether the amount of damages is reasonable in light of the anticipated or actual harm caused by the breach.  Other important factors include the difficulty of establishing proof of loss and the feasibility of obtaining an adequate remedy at the time of breach.

While reasonable liquidated-damages clauses are typically enforceable, penalties are not. A penalty acts to deter nonperformance or to serve as punishment for a breach, rather than being fair compensation to the nonbreaching party.  Thus, if the amount of liquidated damages is disproportionate to the anticipated or actual harm caused, it will be considered an unenforceable penalty.

 Banc of America Leasing & Capital, LLC v. Walker Aircraft, LLC¹ is a recent federal case involving the enforceability of a liquidated-damages clause.  The case involved loans made for the purchase of aircraft.  The loan agreements in question contained acceleration clauses, allowing the lender to demand the full balance of the loans to be due and payable upon the occurrence of specific events of nonperformance by the borrowers.  The borrowers failed to make principal and interest payments, triggering the lender’s right to accelerate the loans.  The borrowers argued that the acceleration clauses were punitive and unenforceable.

The court stated that an acceleration clause is unenforceable if it can be triggered by any breach of the contract’s terms, whether serious or trivial, because a party breaching a minor term of the contract would be forced to pay an amount that is disproportionate to the harm such breach caused the other party.  In the loan agreements at issue, the parties enumerated specific events that would trigger the right to accelerate the loans.  After analyzing these provisions, the court found that the right to accelerate was not triggered by merely any trivial default, but by specific events that the parties deemed to be material.  Moreover, the acceleration clauses were not punitive because they were intended to serve as compensation to the lender for the unpaid balances of the loans. Thus, the court held that the loan acceleration provisions were enforceable.

Another recent case, ING Real Estate Finance (USA) LLC v. Park Avenue Hotel Acquisition LLC,² while not involving equipment finance, is also germane to the issue of liquidated damages.  This case involved a $145 million loan secured by mortgages on real property.  While the obligations of the borrower and guarantors under the loan documents were nonrecourse (that is, the lender’s recovery was limited to the proceeds from the sale of the property through foreclosure), the loan documents allowed for the liabilities of the borrower and guarantors to become full recourse upon the occurrence of specified events.  The borrower eventually became delinquent in paying its property taxes, leading to a tax lien being levied against the property, which the lenders argued triggered the liability of the borrower and guarantors on a full-recourse basis.

Ultimately, under the court’s interpretation of the contract, the borrower and guarantors were not liable for the $145 million debt on a full-recourse basis.  However, the court went on to discuss liquidated-damages provisions in general.  The court stated, "immediate liability for the entire debt is not a reasonable measure of any probable loss associated with the delinquent payment of a relatively small amount of taxes."³  The court created a hypothetical situation under which a loan agreement gave a lender the right to call the entire amount of the loan due in the event that the borrower was one day late paying one dollar in taxes.  This is a scenario in which the amount of damages is clearly disproportionate to the harm caused by the breach.  While this day-late, dollar-short hypothetical is rather extreme, it illustrates that certain "minor" default triggers can render the liquidated-damages provision unreasonable and, consequently, unenforceable.

These recent cases highlight important issues that should be considered when drafting liquidated-damages provisions.  While such provisions are common in contracts, contracting parties should be mindful that they are not always enforceable.  Enforceable liquidated-damages clauses should specifically enumerate the material breaches that will trigger a liquidated-damages provision. Additionally, a fixed sum or formula used to calculate damages should be tied to the harm that the parties anticipate the nonbreaching party will suffer.

¹ 2009 WL 323885 (D. Minn. 2009).

² 2010 WL 653972 (N.Y. Sup. Feb. 24, 2010).

³ Id. at 5.