Under the Bankruptcy Code, a debtor has a right to assume (maintain and perform) or reject (terminate) executory contracts and unexpired leases (other than those related to real property) up until the time that its Chapter 11 plan is confirmed. A contract is an executory contract when both sides have material performance obligations remaining. This power allows debtors to retain favorable contracts while terminating those that are disadvantageous.
Charter-parties have been treated as executory contracts under the Bankruptcy Code. The termination of a charter-party results in a claim for damages in favor of the non-debtor counterparty. Many charter agreements include a stipulated loss value (“SLV”) provision, which sets the amount that the charterer will pay the owner-lessor upon a casualty or loss, or, in addition to any unpaid amounts left on the charter for the use of the ship, on default or early termination of the charter.
Courts considering the calculation of damages in the context of the rejection of equipment leases have struggled with whether SLV provisions are enforceable or instead constitute a penalty, unenforceable as against public policy. This has been contested most frequently in the context of aircraft leases, with relatively little guidance in the shipping industry. Last week, however, Judge Brendan Shannon of the U.S. Bankruptcy Court for the District of Delaware heard argument regarding the enforceability of an SLV provision in the Tidewater bankruptcy cases, ultimately ruling that the provision in question was an unenforceable penalty provision. Judge Shannon indicated that he would hold a hearing in late September to determine the “actual and appropriate damages.”
In the Tidewater cases, six lessors had asserted claims based on SLV provisions included in their respective sale-leaseback transactions. However, five of the six lessors that originally asserted these claims settled, leaving Fifth Third Equipment Finance (“Fifth Third”) as the lone holdout. Fifth Third asserted an SLV claim of $94.1 million for five sale-leaseback agreements, while the debtors contended that the lessor’s “expectation damages” claim should be limited to $34 million.
At the hearing, the debtors argued that the SLV provision was intended to provide insurance against a catastrophic loss, not to provide the lessor with a guaranteed profit, and to allow SLV damages would provide a windfall to the lessor. Fifth Third counter-argued that the SLV provision represented a yield maintenance provision, akin to make whole premiums in bond indentures, which have been permitted in certain situations. Fifth Third also asserted that the provision allows the lessor to get the benefit of its bargain, regardless of what happens in the market. It also argued that actual damages exceeded the SLV so the SLV was not a windfall. Judge Shannon, however, agreed with the debtors that the SLV was an unenforceable penalty. “I find that the proper calculation for the breach damages . . . [is] expectation damages,” Judge Shannon noted.1 Unless the parties settle the issue, a hearing to determine the amount of damages suffered by Fifth Third will be held in late September.
While this determination itself is worth noting, Judge Shannon also addressed another argument advanced by Fifth Third, which may be even more significant. As part of the transaction, the lease obligation owed to Fifth Third by the debtor-counterparty was unconditionally guaranteed by its corporate parent, Tidewater Inc., which is also a Chapter 11 debtor. Fifth Third argues that it is entitled to the SLV amount pursuant to Tidewater Inc.’s guaranty even if the SLV is an unenforceable penalty vis-a-vis its direct contract counterparty.
Fifth Third noted that the U.S. Supreme Court has held that state law determines the amount of allowed claims, and that New York law is clear that a guaranty can be enforceable, even when the underlying obligation is not. The debtors countered that bankruptcy is different – that a bankruptcy is not simply a two-party dispute, and public policy concerns are heightened. If a party gains a windfall, that acts to the detriment of all other creditor constituencies.
Judge Shannon indicated that he would take the matter under advisement, noting that it was a matter of first impression for the court. While he acknowledged the strength of the lessor’s argument that state law determines the amount of the allowed claim and that New York law may provide that the guaranty is enforceable even if the underlying agreement is not, Judge Shannon noted that he is “struggling with the idea that I might disallow a direct claim because it is unenforceable as a matter of public policy, and then turn around and allow the same claim because it comes in the form of a guaranty.”
Seward & Kissel will monitor this situation, and report on any further decisions made by Judge Shannon, as they could have a material impact on maritime sale-leaseback transactions. In the meantime, if you have any questions or comments, please contact one of the attorneys listed below.
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1 Expectation damages are damages awarded when a party breaches a contract that are intended to put the injured party in the same position it would have been had the breaching party fully performed its contractual duties.
