These are turbulent times for aircraft lessors and lenders, especially those involved in large lease and financing transactions involving airline lessees. Whenever such downturns occur, the soundness of the documentation and other practices by a lessor or other financing provider to this industry is often tested, and especially when a lessor or other financier undertakes to enforce its lease remedies set out in the related transaction documents.

Among the most critical remedies for a lessor, whether involving a commercial aircraft, a forklift, high tech assets or manufacturing equipment, is the right to demand and collect liquidated damages from the lessee upon a default under the lease. Further, lessors and other financiers of leased aircraft and other equipment often rely on guaranties by an affiliate of the lessee or an interested 3rd party as essential credit support for the lessee’s damages and other payment obligations. Despite some anxiety raised by a 2019 aircraft lease liquidated damages case,¹  the Wells Fargo v. Synergy case decided in June²  should be useful to lessors and financing providers both as precedent supporting similar actions and as guidance when documenting these remedies.

Background

The case related to two leases between Wells Fargo Trust Company, N.A., as owner trustee ("Wells Fargo") and Oceanair Linhas Aereas S.A. d/b/a Avianca Brazil ("Avianca"), pursuant to which Wells Fargo leased aircraft engines to Avianca, and Synergy Group Corp. ("Synergy") guaranteed Avianca’s obligations under the two leases. After Avianca defaulted under the leases, Wells Fargo brought an enforcement action against Synergy pursuant to the guaranties.

The court was asked to decide motions for summary judgment by Wells Fargo, who was seeking to recover lease damages from Synergy, and by Synergy, seeking a judgment of no liability and arguing that the damages claims under the guaranties are unenforceable. Because, as the parties stipulated, the guaranties were absolute and unconditional, the lease/guaranty obligations were outstanding and Synergy had breached its guaranties, the court only needed to decide whether the damages provisions under the leases and guaranties were valid, and if so, the amount of damages to be awarded to Wells Fargo.

Lessor’s Damages Claim

The damages claimed by Wells Fargo were based on the default remedy provisions in the leases and guaranties. The lease damage provisions included: (1) past due rent and use fees; (2) the present value of future rent for the remaining terms of the leases (“future rents”); (3) compensation for failure to return the engines in accordance with the lease requirements (“end of lease payments”); (4) costs to repair any defects in the condition of the engines (“repair and maintenance costs”); and (5) costs for repossessing the engines.³ These damage amounts correlated with the damages remedies in the leases, which also included a mitigation credit to be applied to any such damages claim in the amount of any proceeds of a sale or lease by Wells Fargo of the engines if returned.

Wells Fargo also demanded payment, pursuant to the guaranties, of attorneys' fees and expenses Wells Fargo incurred in enforcement, as well as prejudgment interest accruing on the unpaid lease damages amounts. As noted above, Synergy was not disputing that its guaranties were absolute and unconditional, that the claimed amounts were outstanding nor that it had failed to pay the guaranteed amounts. Nor did Synergy dispute the amounts of future payments, end of lease payments, repair and maintenance costs or repossession costs claimed by Wells Fargo.⁴ However, Synergy did dispute the enforceability of Wells Fargo’s claim for future rents and end of lease payments and challenged the admissibility of evidence on which certain of the damages amounts were based.⁵ Although the court rejected all of Synergy’s challenges to Wells Fargo’s claims, the main focus of this Alert relates to the liquidated damages amounts challenged by Synergy, and awarded to Wells Fargo by the court by its summary judgment regarding the same.

Why the Court Concluded that the Damages Provisions Were Enforceable

Synergy argued that Wells Fargo should not receive future rent or end of lease payments under the leases because the lease remedy provisions on which these damages were based “are punitive, against public policy and therefore unenforceable.”⁶ The court considered each of Synergy’s enforceability challenges, and its analysis of the applicable law focused on Article 2A, Section 504 of the New York UCC and various cases cited in the opinion interpreting § 2-A-504.⁷ 

Future Payments. Synergy argued that the lease provisions providing for future rent damages were unenforceable because they put Wells Fargo in a better position than it would have enjoyed if Avianca had fully performed under the leases, because Wells Fargo would be entitled to receive both the future payments under the leases as well as any lease or other disposition proceeds attributable to any returned engines.⁸ 

However, the court ruled that the future payments “ensure that [Wells Fargo] receives the benefit of its bargain, i.e. rent and use fees through the duration of the leases” and that they “put [Wells Fargo] in the position it would have been in had there been no breach.”⁹  The court disagreed with Synergy’s “double-dip” (punitive damages) argument, stating that Wells Fargo is not put in a superior position simply because the lease “entitles [Wells Fargo] to receive both the future payments and the option to lease or dispose of any returned engines.”¹⁰  Synergy’s argument was also hindered by a mitigation credit provision expressly providing that any demand for future payments be reduced by the amount of the proceeds of any sale or re-lease of the engines by Wells Fargo. Further, the court found that the fact that the lease afforded Wells Fargo "sole discretion" as to whether it leased, sold or held idle the returned engines did not make the future payments remedy punitive.¹¹

End of Lease Payments. Synergy also challenged Wells Fargo’s claim for damages pursuant to the end of lease payments provisions in the leases, including Avianca’s express agreement to compensate Wells Fargo for any reasonable expenses for repairing and refurbishing the engines to the return condition required by each lease. Synergy argued that this express agreement should not be enforced because requiring Synergy to pay these return condition deficiency damages improperly "transfer[s] . . . the risk of idiosyncratic depreciation or damage to a particular engine to Avianca Brazil."¹²  

The court disagreed, reasoning “the parties expressly agreed to this risk allocation in the [leases],” including in the damages provision on which Wells Fargo had based its claim.¹³ The court, citing what it considered to be precedent, opined that “[a] court should enforce the ‘parties abilities to allocate risk by mutual agreement’ as doing so enables the parties to ‘form reliable expectations about their potential financial exposure with respect to the duties and liabilities that they have contractually assumed.’"¹⁴  Further, the court stated that “[t]his principle holds true particularly where, as here, the parties are sophisticated commercial entities, capable of determining how to allocate their risks and adjust their pricing accordingly.”¹⁵

The court did not consider Synergy’s argument to be a bona fide challenge to the damages calculations, and attributed Synergy’s various arguments to “a misunderstanding of N.Y. U.C.C. § 2-A-504 and the principle against punitive damages.”¹⁶   From the court’s perspective, Synergy was arguing that their responsibility should be limited to past due rent and use fees which accrued prior to the return of the engines, because Wells Fargo regained possession of the engines and Avianca was no longer using them. The court found that this view ignored Avianca and Synergy’s express promises made to Wells Fargo, and would deny the transaction benefits it expressly bargained for, “a steady stream of payments for the duration of the Leases and the eventual return of the engines or payment of the ‘Agreed Value.’”¹⁷ By upholding the damages provisions being challenged by Synergy, the court held Synergy responsible for damages that were “direct analogues” to Synergy’s promises.¹⁸  

The future rent damages provisions in the leases were consistent with both modern (prudent) practice among sophisticated parties to a commercial aircraft operating lease and the law, i.e., the future rents being demanded began to toll after the engines were recovered, were present valued using a reasonable discount rate and were subject to a mitigation credit in the amount of any proceeds attributable to the lessor’s sale or lease of the engines after they were recovered.¹⁹ The damages provisions covering the end of lease payments are also consistent with recognized industry practices and the law. Generally, a lessor is entitled to recover residual value damages suffered by reason of a lessee’s breach of its promises under a lease, particularly if those damages would not, at the time they were agreed to,²⁰ appear to have provided the lessor with a windfall or be deemed punitive to the lessee.²¹

Republic Case Not Followed

This case is particularly noteworthy because the court did not follow the interpretation by the court in the In re Republic Airways Holdings, Inc. opinion published in February 2019 regarding the enforceability of liquidated damages claims involving a commercial aircraft lease between sophisticated parties.²² In that case, the United States Bankruptcy Court for the Southern District of New York refused to enforce expressly bargained for remedies against a lessee or guarantor because the court deemed the liquidated damages to be punitive, and against public policy.²³ Although the damages formula and circumstances were different in certain respects than the Synergy case, the two cases did share a fundamental consideration: should sophisticated parties be held accountable for their express contractual promises that they believed to be a reasonable allocation of risks at the time those promises were made?

Conclusion

The notions of freedom of contract among sophisticated commercial parties and assessing the reasonableness of damages remedies as of the execution of the related lease documents (i.e., not retrospectively by taking into account what ultimately occurred) are both strongly supported by UCC Section 2A, and well-reasoned cited precedent.²⁴ The Synergy opinion is useful not only as support for a lessor’s remedy claims if challenged by a lessee in a court action or otherwise, but also when considering how best to draft reliable damages remedies. As was the case with the leases in Synergy, any liquidated damages in the nature of rent acceleration should commence after the leased asset is recovered, be present valued as of the date of the demand using a reasonable discount rate and be reduced by a mitigation credit that aligns with the applicable provisions of UCC Section 2A. Although UCC Section 2A does not require a lessor to lease or otherwise dispose of leased assets if they are recovered after a default, a lessor must afford a lessee a credit against its accelerated rent obligations calculated so as to reflect the lessor’s actual recovery if it re-leases the leased asset under a lease that is similar to the defaulted lease, or the fair market rental value of the leased asset re-leased under a similar lease, in both cases for the remaining term and discounted to present value using the same discount rate as was used when discounting the accelerated rent.²⁵

^{1 In re Republic Airways Holdings Inc., 598 B.R. 118 (Bankr. S.D.N.Y. 2019).
2 Wells Fargo Tr. Co., N.A. v. Synergy Grp. Corp., 18 Civ. 11151 (LGS), 2020 U.S. Dist. LEXIS 100751 (S.D.N.Y. June 9, 2020).
3 In the event that Avianca did not return the engines, the Agreement called for them to pay an “Agreed Value” to Wells Fargo. Id.
at *4-5.
4 Synergy did challenge Wells Fargo’s calculation of the use fees for one of the engines, but the court rejected that challenge. Id. at *25.
5 Id. at *4.
6 Id. at *9.
7 Id. at *9 (citing N.Y. U.C.C. Law § 2-A-504 ("[D]amages payable by either party for default . . . 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."); JMD Holding Corp. v. Cong. Fin. Corp., 4 N.Y.3d 373 (N.Y. 2005); CVS Pharmacy, Inc. v. Press Am., Inc., 377 F. Supp. 3d 359, 375 (S.D.N.Y. 2019); Rubin v. Napoli Bern Ripka Shkolnik, LLP, 118 N.Y.S.3d 4 (1st Dep't 2020)).
8 Id. at *5-6.
9 Id. at *11.
10 Id.
11 Id. at *12.
12 Id. at *14.
13 Id.
14 Id. ("Parties to a contract are generally free to allocate risks . . . as they choose [and courts should] . . . not re-write how the parties defined their rights and obligations [and] allocated their risks . . .").
15 Id. at *15. The court cited, as an example, In re Lyondell Chem. Co., 585 B.R. 41 (S.D.N.Y. 2018), noting that Lyondell recognized that "‘New York courts have routinely enforced . . . provisions when contracted by sophisticated parties ... [as the provisions are] a means of allocating economic risk[s]’ between them.”
16 Id. at *15.
17 Id. at *16.
18 Id. The court further notes a “corollary principle” - Synergy “cannot attempt to undo the promises it has already made in the guise of challenging purportedly punitive damages provisions. Id.
19 Id. at *4, *12; U.C.C. § 2A-528.
20 U.C.C. § 2A-504 Official Comments (“A liquidated damages formula that is common in leasing practice provides that the sum of lease payments past due, accelerated future lease payments, and the lessor's estimated residual interest, less the net proceeds of disposition (whether by sale or re-lease) of the leased goods is the lessor's damages.”).
21 Id.
22 Republic, 598 B.R. 118.
23 Id. at 121; Arlene N. Gelman & Edward K. Gross, A Valentine’s Day Massacre of Liquidated Damages: In re Republic Airways Holdings Inc., 37 J. OF EQUIPMENT LEASE FINANCING 1 (Spring 2019).
24 See, e.g., Wells Fargo Bank NW, N.A. v. U.S. Airways Inc., 2011 N.Y. Slip op. 52188, 2011 WL 6141034 (N.Y. Co. Supreme Ct. Dec. 1, 2011); In re Snelson, 305 B.R. 255, 264-65 (Bankr. N.D. Tex. 2003); Pacificorp Capital Inc. v. Tano Inc., 877 F. Supp. 180 (S.D.N.Y. 1995).
25 U.C.C. § 2A-528.}