Liquidated damages in true leases: applicable law

Uniform Commercial Code Section 2-A-504 is the applicable law regarding liquidated damages in a lease agreement. Section 2-A-504(1) provides that: “Damages payable by either party for default . . . including . . . loss or damage to lessor’s residual interest, 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 . . . .”

As an exemplar, the Official Comment to Section 2-A-504 (the Official Comment) provides a commonly accepted formula used in leasing practice to liquidate the lessor’s damages for breach or early termination: the sum of (1) lease payments past due, plus (2) accelerated future lease payments, plus (3) the lessor’s estimated residual interest, determined ex ante, less (4) the net proceeds of disposition (whether by sale or re-lease) of the leased goods.

The Official Comment recognizes that stipulated loss schedules are common and that whether such a formula is enforceable will be determined in the context of each case by applying a standard of reasonableness in light of the harm anticipated when the formula was agreed to between the parties, i.e., at the inception of the lease transaction. Lessees that contest the reasonableness of a liquidated damages formula for the most part attempt to analyze the reasonableness of the formula ex post, which is directly contradicted by the plain language of the statute’s direction to assess the “then anticipated harm.”

The leading case analyzing UCC 2-A-504

The standard for analyzing a liquidated damages provision was recognized by the Third Circuit Court of Appeals in its 2003 Montgomery Ward opinion, which analyzed a liquidated damages provision in a lease agreement governed by UCC 2-A-504. The Third Circuit acknowledged that the test of reasonableness is “ex ante rather than ex post.” The Third Circuit also declared that a liquidated damages provision would be unreasonable if it provided substantially more recovery for a lessor than the lessor’s actual damages. The Third Circuit explained that a lessor’s actual damages will be the sum of (1) the amount of any unpaid rent, (2) the present value at the time of breach of the monthly rentals for the then-remaining term of the lease and (3) the then-present value of what would have been, when the lease terms began, the anticipated aggregate residual value of the leased equipment at the scheduled termination of the leases.

Montgomery Ward does not generally invalidate liquidated damages provisions: it recognizes their validity. What Montgomery Ward prohibits is a liquidated damages provision that provides a greater recovery for the lessor than full performance by the lessee.

The Montgomery Ward court addressed a lease that had lower monthly rent so that the lessor would only recover its profit if the lease was renewed. Because the lessor’s profit was not amortized over the lease term, the liquidated damages in Montgomery Ward included the lessor’s entire unamortized profit. Thus, the liquidated damages put the lessor in a better position than its anticipated expectancy (or actual) damages at the commencement of the lease. The Third Circuit, therefore, held that the liquidated damages provision was unenforceable.

The alternative to liquidated damages in a true lease

The Third Circuit held that if liquidated damages are unenforceable, then a lessor is entitled to its actual damages, which are to be calculated by the following formula: at the time of breach, the lessor is entitled to receive the sum of (1) the amount of any unpaid rent, (2) the present value at the time of breach of the monthly rentals for the then-remaining term of the leases and (3) the then-present value of what would have been, when the lease term began, the anticipated aggregate residual value of the leased equipment at the scheduled termination of the leases.

Given the recognition that a lessor is entitled to the present value of the residual value of the equipment determined as of the origination of the term of the lease, this formula will likely result in the lessor recovering an amount close to (and in some cases, greater than) the amount recoverable as liquidated damages.