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No Windfall From Liquidated Damages

Dispatches from the Trenches

This issue of Dispatches from the Trenches: (a) discusses the invalidation of liquidated damages provisions that purport to grant the lessor more profit than it was guaranteed to receive if the lessee fully performed; (b) reminds lessors to be careful when dealing with lessees so as to avoid waiving the lessors' rights against the lessee after default; and (c) may prompt some lessors to see if the end of term notice periods in their leases are consistent.

In re Montgomery Ward Holding Corp., 325 F.3d 383 (3rd Cir. Apr. 24, 2003).

This case serves as another reminder that liquidated damages provisions must only compensate lessors for the loss of their bargain and cannot result in a windfall.

Meridian Leasing Corporation ("Meridian") purchased new computer equipment for approximately six million dollars and leased it to Lechmere, Inc. ("Lechmere") under a true lease pursuant to which the monthly payments totaled less than four million seven hundred thousand dollars. Meridian offered a low rental rate to obtain Lechmere's business in a competitive market, gambling that Lechmere would renew the lease at a rate which would have allowed Meridian to realize a substantial profit over the course of the renewal term. Unfortunately for Median, the gamble did not pay off. Montgomery Ward and its affiliates, including Lechmere, declared bankruptcy with ten months still left on the lease. Lechmere rejected the lease contract pursuant to its statutory rights under §365 of the Bankruptcy Code and Meridian sued for damages under the liquidated damages provision in the lease.

The liquidated damages provision provided that, in case of breach, Lechmere would pay Meridian a sum equal to the "Casualty Value" of the equipment. As is common in the industry, the Casualty Value was provided by way of a spreadsheet attached to the lease. Although the lease contained standard language that the Casualty Value would be paid as liquidated damages for loss of a bargain and not as a penalty, the Court noted that "the tyranny of labels does not extend to the terms that are attached by parties to a contract [and that a] determination of whether a contractual provision for damages is a valid liquidated damages provision or a penalty clause is a question of law for the court." The court then analyzed the provision in the lease to determine if it placed Meridian "in a position legally superior to the one that it would have occupied had the lease been fully performed."

At the time Lechmere defaulted on the lease, the Casualty Value of the equipment was three and one-half million dollars but Lechmere owed only one and one-half million in rent through the remainder of the term. Thus, Lechmere actually owed Meridian two million dollars more in liquidated damages than it would have owed had it paid everything due Meridian under the lease and chosen to return the equipment instead of purchasing it or renewing the lease. Of course, Meridian had designed the liquidated damages clause so that it would recover the profit it had hoped it would realize upon a renewal of the contract.

The court held that Meridian could not seek, as liquidated damages, profits that it wasn't guaranteed under the actual contract. Rather, Meridian was only entitled to the sum of the present value of the future rentals to the end of the lease plus the present value of the Meridian's remainder interest in the computers at the end of the lease in the event Lechmere elected to return the equipment. Since the computer equipment was worth substantially les than the two million plus dollars projected by the liquidated damages provision, the court struck down the provision as an unenforceable penalty.

IOS Capital, Inc. v. Jacobi, 2003 WL 21241369 (Mo. App. W.D.)

A company operated by a husband and wife doing business as South 65 Storage ("Lessee") entered into the a lease with IOS Capital, Inc. ("Lessor") covering several pieces of office equipment. When Lessee failed to make a lease payment, Lessor called a default. The central issue at trial was whether Lessor, by picking up the leased equipment, accepted Lessee's offer to voluntarily return the equipment in exchange for a cancellation of the lease. The state appellate court held that, although Lessee made an offer to cancel the lease, Lessor's repossession of the equipment did not constitute acceptance of the offer because Lessor was merely exercising its contractual rights under the lease.

The wife executed a lease on behalf of Lessee and, after making 13 monthly payments, Lessee mailed a letter to Lessor asking it to cancel the lease and to pick up the equipment. According to the letter, Lessee was "just not able to continue to make the monthly payments." A short time later, Lessor picked up the equipment but left a receipt that specifically stated that "pick-up of equipment does not release customer of contractual obligations." When Lessor sued Lessee for remaining obligations owed under the lease, the trial court ruled for Lessee, holding that Lessee's letter constituted an offer for the voluntary return of the equipment in exchange for the cancellation of the lease and that Lessor unilaterally accepted the offer by picking up the equipment. This purported acceptance, the trial court determined, was the final element of an accord and satisfaction releasing Lessee from further obligations under the lease.

Lessor appealed and the appellate court rejected the trial court's interpretation of the events. The court reasoned that the terms of the lease explicitly provided that it was non-cancelable and that the failure to make payments would result in default. Accordingly to the court, Lessor's repossession of the equipment could not result in an accord and satisfaction since Lessor "was doing what it was already entitled to do under the contract." The court also noted that Lessor's letter to Lessee, which stated that it was still bound by the lease, constituted overwhelming evidence that Lessor was not accepting Lessee's offer.

As a side note, the appellate court rejected arguments that the lease was not binding on Lessee because it was only signed by the wife. The appeals court found that the husband and wife were jointly and severally liable for the lease obligations because they both were registered with the state as doing business as South 65 Storage when the lease was signed. Since the husband was an undisputed owner of the business, the lease listed South 65 Storage as the party, and the husband had apparently granted his wife the authority to bind the business to legal obligations as Office Manager, the husband could not claim that his failure to sign the lease agreement prevented him from being obligated by its terms.

Digital Storage, Inc. v. ePlus Group, Inc., 2003 WL 21054656 (6th Cir. May 5, 2003).

In this case, ePlus Group, Inc. ("ePlus") leased computer equipment to Digital Storage, Inc. ("Digital"). The lease provided that the term would automatically renew for a three-month period unless a ninety-day notice was given by either party of its intent to terminate the lease. The lease also contained a provision allowing Digital to purchase the equipment at its fair market value at the end of the lease, so long as Digital gave a sixty-day notice of its intent to purchase. With ninety days remaining on the lease, Digital gave notice of its intent to terminate. With sixty days left on the lease, Digital gave notice of its intent to purchase. However, ePlus refused Digital's notice and argued that Digital could not exercise the purchase option after giving notice of its intent to terminate the lease.

The court rejected ePlus' argument, pointing out that the lease did not contain any language that would cause the purchase option to be invalidated once a lessee gave the ninety-day notice of intent to terminate. The court essentially held that, when a contract requires a period of notice for termination, all its terms remain in full force after notice is given until the specified date for termination. The court ruled for Digital and ordered ePlus to sell the equipment to Digital for the value at which it had been appraised.

Article appeared in the September,  2003 issue of the Monitor.
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