In complex long-term charters for vessels or finance leases in respect of vessels under the U.S. Uniform Commercial Code (“UCC”) and its Article 2A (governing commercial matters relating to finance leases) and under other similar law, a charterer’s or lessor’s damages under a charter or lease— both generally upon a payment default or in the event of a casualty—are often liquidated in stipulated loss value (“SLV”) provisions. These provisions ensure that the lessor/charterer gets the benefit of its bargain. It insulates the lessor/charterer, in part, from unusual market downturns impacting vessel value or casualties.

A typical SLV calculation enables the present value recovery of the charterer’s/lessor’s unrecovered investment, residual value in the vessel, and the recapture of tax benefits and certain fees and costs, less a credit for the value of the vessel, if the stipulated loss value is repaid by the charter party/lessee, a net proceeds measure.1 Schedules to identify the stipulated loss are a common feature of such charters and leases.2 Now, any SLV provision under Article 2A of the U.S. U.C.C., for example, must be reasonable as of lease/charter commencement.3 Oftentimes, these kinds of charters and leases are backed by absolute, unconditional guaranties of such loss value from affiliates of the charter parties.4

SLV Provisions Consistent with Article 2A of the U.S. U.C.C. and Related Law and Policy

Article 2A and maritime law relating to vessel leases and charters are supported by public policy valuing free contractual relations, clearly contemplating lease counterparties entering liquidated damage provisions. 

SLV agreements are usually negotiated by sophisticated parties where the lessee/charter party benefits from the lease structure in various ways (off balance sheet equipment financing that is tax beneficial, etc.). 

Reasonableness in this context focuses on whether the lessee/charter party’s exposure to the SLV is based on understood market conditions at the time the lease/charter closed, reduces over time as payments are made, and is further reduced by the recapture of the vessel’s value if and when the SLV is satisfied. Likewise, under many sovereigns’ commercial law, such as the law of New York sureties, absolute, unconditional guaranties of exposures by sophisticated parties are generally enforced—notwithstanding whether the underlying primary obligation is unenforceable (in whole or in part).5

Conflicting Law and Policy: Bankruptcy Law’s Commitment to Distributional Equity

U.S. bankruptcy law looks to state law to determine the extent of the contractual rights of a debtor and its contract counter parties. But any bankruptcy in the United States is a collective proceeding balancing the interests, not just of a debtor and a specific creditor or counter party, but of all a debtor’s creditors and other stakeholders. Accordingly, as a chapter 11 debtor inventories its executory contracts (like charters) and decides whether to reject (making an economic breach of the contract and fixing resulting damages as of the petition date of the bankruptcy) or assume the same as it reconciles claims against its estate, the debtor, as a trustee, has tools to maximize value for the collective by pressing down and reducing claims. Claims that are unenforceable as penalties, for example, will not be allowed. And in all yield maintenance contexts, including in respect of SLV provisions, debtors fight to limit the assertion of such claims as penalties or as otherwise unenforceable under the terms of the underlying contract.

The power of the bankruptcy court to identify and disallow penalty claims, and the duty of that same court to enforce underlying non-bankruptcy, commercial law when defining contract rights, does come into tension when lessors/charterers seek to enforce SLV provisions.

If a SLV provision and related guaranties are enforced, the allowance of the full SLV claim can have a significant inflating impact on a claims pool, reducing general recoveries to creditors. So, the power of the bankruptcy court to identify and disallow penalty claims, and the duty of that same court to enforce underlying non-bankruptcy, commercial law when defining contract rights, does come into tension when lessors/charterers seek to enforce SLV provisions.

Republic Airways and Tidewater 

This year in Republic Airways, the New York Bankruptcy Court found that a SLV-based damage claim was an unenforceable penalty and, accordingly, refused to enforce an otherwise unconditional guaranty of the true lease in question. The debtors in that case had rejected the aircraft lease and the lessor had asserted damages under the SLV as a result of that rejection. The court found that the SLV damage measure acted as a penalty because it effected an unconditional transfer of residual value risk upon the rejection without a cognizable connection to the anticipated harm caused by the breach or default itself. The court then refused to enforce the lease guaranty of the SLV damage claim because the SLV claim was subject to an unwaivable defense (this is contra the holding in 136 Field Point Circle). 

Further, in an unreported decision, In re Tidewater, Inc., Bankr. Case No. 17-11132 (BLS) (Bankr. D. Del., Aug. 31, 2017), the Delaware Bankruptcy Court reached a similar result. In the context of the rejection of bareboat charter agreements for certain vessels, the Delaware Court ruled that the SLV provisions in the charters were penalties unenforceable as a matter of public policy and relevant Third Circuit precedent, which the court found was not abrogated by the adoption of U.C.C. section 2-A-504 after those senior circuit decisions were handed down. The Delaware Court took under advisement the question of the enforceability of a related guaranty.

Unresolved Tensions in the Law Relating to SLV Enforcement in U.S. Bankruptcy

It is important to note that the Republic Airways/Tidewater opinions have not settled this area of the law at all. Each decision is highly fact sensitive and lessor interests in each case had very colorable grounds for appeal. For example, the Tidewater court’s insistence on the enforcement of circuit precedent that addressed the character and nature of liquidated damages as an unenforceable penalty before Article 2A was amended can be challenged because, among other things, Article 2A contemplates residual value loss as an element of damages that can be liquidated in true leases. 

In respect of the Republic Airways decision, in determining whether SLV claims were punitive, the New York court focused on the lessor’s actual damages at the point of rejection rather than considering whether the damage claim based on the SLV at issue would have been deemed “reasonable at the outset of the lease” (the U.C.C. section 2-A-504 standard). Further, the Republic Airways court’s refusal to enforce a surety on the grounds that a defense existed to the guaranteed liquidated damages provision in question is inconsistent with a number of federal and state court decisions applying New York law to enforce unconditional guaranties strictly.