A Lessor’s Damages for a Lessee's Default - International Law Office

What rights to damages does a lessor have when a lessee defaults on a lease agreement for personal property and the damages are not otherwise covered by a liquidated damages provision in the lease?(1) Do those rights depend on whether the lessor retains the goods or disposes of the goods? If the lessor disposes of the goods, do those rights depend on whether the disposition was by lease, by sale or by some other method? Sections 2A-527 ("Lessor’s Rights to Dispose of Goods") and 2A-528 ("Lessor’s Damages for Non-Acceptance, Failure to Pay, Repudiation or Other Default") of the Uniform Commercial Code provide the starting point from which one can begin to answer these questions.

In a situation where a lessee defaults on a lease agreement, and the lessor has elected to retain the goods concerned or a disposition of the goods has occurred which does not comply with Section 2A-527 of the code, Section 2A-528 permits the lessor to recover the following as damages from the lessee:

• accrued and unpaid rent as of the date of default(2) if the lessee has never taken possession of the goods or, if the lessee has taken possession of the goods, as of the date the lessor repossesses the goods or an earlier date on which the lessee makes a tender of the goods to the lessor;
  
  
• the present value(3) as of the date determined above of the total rent for the then remaining lease term of the original lease agreement minus the present value as of the same date of the market rent(4) at the place where the goods are located computed for the same lease term; and
  
  
• any incidental or consequential damages - including any commercially reasonable charges, expenses or commissions (i) incurred in stopping delivery of the goods, in the transportation, care and custody of goods after the default, or in connection with return or disposition of the goods; or (ii) otherwise resulting from the default - minus expenses saved in consequence of the lessee’s default.

However, if these damages do not put the lessor in as good a position as performance would have, damages may be calculated as follows:

• present value of the profit,(5) including reasonable overhead the lessor would have made from full performance by the lessee;
  
  
• any incidental or consequential damages;
  
  
• due allowance for costs reasonably incurred; and
  
  
• due credit for payments or proceeds of disposition.

If, after a lease default, the lessor elects to dispose of the leased goods, Section 2A-527(1) permits such disposition to take place by lease, sale or some other method. The disposition is subject to the discretion of the lessor and a function of the lessor’s commercial judgement.(6) If the lessor makes any profit on such a disposition, the lessor is not accountable to the lessee for that profit.(7) Even if the lessor fails to comply with one or more requirements of Article 2A of the Uniform Commercial Code, any subsequent lessee or buyer which in good faith and for value leases or buys the goods from the lessor takes the goods free of the original lease contract and any rights of the original lessee.(8)

Pursuant to Section 2A-527(2), if the disposition is by a new lease "substantially similar" to the original defaulted lease,(9) the lessor may recover the following as damages from the lessee:

• accrued and unpaid rent as of the date of the commencement of the term of the new lease agreement;
  
  
• the present value, as of the same date, of the total rent for the then remaining lease term of the original lease agreement, minus the present value, as of the same date, of the rent under the new lease agreement applicable to that period of the new lease term which is comparable to the then remaining term of the original lease agreement; and
  
  
• incidental damages less expenses saved in consequence of the lessee’s default.

If the lessor attempts to dispose of the goods concerned by lease agreement but fails to satisfy the criteria in Section 2A-527(2), or if the lessor disposes of the goods concerned by sale or by another method, Section 2A-527(3) allows the lessor to recover damages from the lessee as if the lessor had elected to proceed under Section 2A-528 and not dispose of the goods.(10)

Sections 2A-527 and 2A-528 are interrelated and provide for different methods of determining damages based on the lessor’s circumstances. However, as a prerequisite to recovery under Section 2A-527 or 2A-528, several additional requirements must be established. First, the default must be one of the following types:

• where the lessee defaults by either (i) wrongfully rejecting or attempting to revoke acceptance of goods, (ii) failing to make a payment when due, or (iii) repudiating with respect to a part or the whole;(11)

• where the lessee defaults in such a way that substantially impairs the value of the lease contract to the lessor;(12)
  
  
• where the lessor (i) refuses to deliver the goods because of the lessee’s insolvency or repudiation, or (ii) takes possession of the goods from a carrier or bailee because of such insolvency;(13) or
  
  
• where the lessor and lessee agree that the situation is a default.(14)

Second, the lessor and lessee cannot have agreed to calculate damages in any one of the following ways: (i) by providing for liquidated damages in the lease agreement;(15) or (ii) by including rights and remedies for default to the exclusion of those provided in Article 2A of the code, or limiting or altering the measure of damages recoverable under Article 2A.(16)

If the parties to a lease include any of the above measures, the parties calculate damages in accordance with their agreement and do not use Sections 2A-527 and 2A-528. However, if any such damages provisions in the lease are deemed to be unenforceable or unconscionable, or fail in their essential purpose, the damage determination reverts to the applicable Uniform Commercial Code provisions.(17)

A lessor must meet additional requirements before it can recover damages under Section 2A-527(2). The new lease agreement with a third party must be both substantially similar to the original lease agreement and made in good faith and in a commercially reasonably manner. While 'good faith' and 'commercial reasonableness' are familiar terms in the code, the concept of 'substantial similarity' is not a familiar term.(18)

The determination that a new lease is substantially similar to an original lease is made on a case-by-case basis, and is guided by terms within the lease that allocate cost and risk between the parties to the lease. For example, such terms may be:

• options to purchase or release;
  
  
• representations, warranties and covenants by the lessor to the lessee, as well as those to be provided by the lessee to the lessor; or
  
  
• services, if any, to be provided by either the lessor or lessee.

These terms are evaluated separately and not with scientific precision. Rather, commercial judgement is used to determine whether the lease terms, when viewed together, lead to a finding that the new lease is or is not substantially similar to the original lease. In comparing two leases, it is possible for a new lease to be substantially similar to the original lease, even if the terms of the new lease extend beyond the remaining terms of the original lease, and even if the beginning and ending dates of the two leases are not the same.(19)

Thus, if a lessee defaults on a lease agreement, the lessor has a variety of options under Sections 2A-527 and 2A-528 of the Uniform Commercial Code. Assuming the default meets certain statutory requirements, and assuming the parties have not contracted for a specific manner in which to calculate damages, the lessor can retain the goods or dispose of the goods. If the lessor disposes of the goods, it can do so by lease, sale or some other method. The lessor can choose which course of action to take, but the type and amount of damages that a lessor ultimately receives under the code will directly depend on what actions the lessor does take.

For further information on this topic please contact Timothy Lynes at KMZ Rosenman by telephone (+1 202 625 3500) or by fax (+1 202 298 7570) or by email (timothy.lynes@kmzr.com).

Endnotes

(1) UCC Section 2A-504 addresses the issue of enforceability of liquidated damages clauses in a lease. Such damages must be “reasonable in light of the then anticipated harm caused by the default”.

(2) A 'default' is different from an 'event of default'. The latter becomes the former only after the expiration of any relevant grace period and compliance with any notice requirements under Article 2A and the lease agreement, and depends on whether, as a matter of fact or law, the event of default has been waived, suspended or cured. UCC Section 2A-528 cmt 2.

(3) 'Present value' is defined as “the amount as of a date certain of one or more sums payable in the future, discounted to the date certain by use of either an interest rate specified by the parties if that rate is not manifestly unreasonable at the time the transaction is entered into or, if an interest rate is not so specified, a commercially reasonable rate that takes into account the facts and circumstances at the time the transaction is entered into”. UCC Section 2A-103(1)(aa).

(4) See UCC Section 2A-507 ("Proof of Market Rent: Time and Place").

(5) In calculating profit, courts should consider expected appreciation of the goods, reasonable benefit or profit expected by the lessor, and the concept of present value. UCC Section 2A-528 cmt 5.

(6) Section 2A-527 cmt 1. In New York, the lessor is given the specific election to proceed under Section 2A-527 or Section 2A-528 even if the disposition would otherwise qualify under Section 2A-527. NYUCC Section 2A-527(3) (McKinney 2004).

(7) UCC Section 2A-527(5). Also, a lessee that has rightfully rejected or justifiably revoked acceptance shall account to the lessor for any excess over the amount of the lessee’s security interest. Id (citing UCC Section 2A-508(4)).

(8) UCC Section 2A-527(4).

(9) In addition to being substantially similar to the original lease, the new lease would be made in good faith and in a commercially reasonable manner.

(10) Under some of the circumstances where a lessor may proceed under Section 2A-528, the lessor may also be able to proceed under Section 2A-529 ("Lessor’s Action for the Rent"). UCC Section 2A-528 cmt 1.

(11) UCC Section 2A-523(1).

(12) UCC Section 2A-523(4)(a).

(13) See UCC Sections 2A-525, 2A-526. The lessor does not have to remove the goods concerned from the lessee’s possession. UCC Section 2A-525(2).

(14) UCC Section 2A-527(1).

(15) See UCC Section 2A-504.

(16) UCC Section 2A-503. See also UCC Section 1-302(a) (obligations of good faith, diligence, reasonableness and care cannot be disclaimed).

(17) UCC Section 2A-503(2).

(18) UCC Section 2A-527 cmt 4.

(19) UCC Section 2A-527 cmt 5, 7.