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OUTLINE OF A CHAPTER 11 CASE: DUTIES AND LIABILITIES OF THE

DEBTOR IN POSSESSION

By: James H. Rollins Holland & Knight LLP

I. INTRODUCTION

The purpose of this memorandum is to explain how a typical case under Chapter 11 of the Bankruptcy Code works. Note that in the so-called “mega cases”, such as those of UAL or Enron, some of the rules and procedures that would otherwise apply in ordinary cases may be modified by “first-day orders” entered in the interest of minimizing the operational disruptions inherent in a bankruptcy filing. See, for example, the Proposed First Day Agenda in the UAL bankruptcy case attached hereto.

A petition for reorganization under Chapter 11 commences the bankruptcy case and authorizes the Debtor’s officers, directors, and controlling persons to continue operating as a “debtor in possession” pursuant to Section 1108 of the Code (unless otherwise indicated, section references below refer to sections of the Bankruptcy Code). Nonetheless, the Debtor may not operate its business or manage its property as before the filing of the petition.

A. THE BUSINESS UNDER CHAPTER 11.

There are four general differences between pre-bankruptcy operation of the business and operation of the business under Chapter 11:

First, management of the debtor in possession will operate the business as fiduciaries of all creditors and interest groups, not just as fiduciaries of the corporation or its stockholders.

Second, actions of the Debtor and its management will be subject to the scrutiny of the court and all creditor and other interest groups.

Third, the court has absolute authority and control over the operation of the business and management of the Debtor’s property.

Fourth, the Debtor may carry out operations in “the ordinary course of business” without obtaining court approval first but must obtain prior court approval for any transactions outside of the ordinary course of business.

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Bankruptcy UpdateWhy Are the Airlines Filing?

Timeline of a Chapter 11 Case

What Are the Key Bankruptcy Code Provisions That Impact Equipment Lessors?

The Other Factor Affecting Your Debtor –Labor Negotiations


Why Are the Airlines Filing?To Facilitate Cost Cutting

• Fuel (Bankruptcy Offers Little or No Help)

• General Overhead▫ One-Time Haircut for Prepetition Claims (Nominal Help) ▫ Rejection of Real Estate Leases and Cap on Damages

• Fleet Size and Fleet Costs• Labor Costs


Why Are the Airlines Filing?

Ability To Restructure Pre-Petition Debt Without Unanimous Consent

To Facilitate Financing

To Buy Time


Timeline of a Chapter 11 CaseDay 1

• Automatic Stay• Motions to Authorize Financing

* Use of Cash Collateral* DIP Financing



Day 1 (continued)

• Other First Day-Motions

* Case Management and Other Procedural Matters* Retention of Professionals* Motions Pertaining to Business Operations* Procedures for Assumption or Rejection of

Executory Contracts



Days 1 – 60

• Appointment of Committees• Motions to Lift Stay or For Adequate

Protection• Negotiations With Equipment Lenders/

Lessors• Negotiations With Labor



Days 1 – 60 (continued)

• Section 1110(a) Agreements• Section 1110(b) Stipulations• Rejection/Abandonment of Equipment


Timeline of a Chapter 11 CaseDay 60 and Thereafter

• Motions to Assume/Reject Contracts• Motions to Abandon Burdensome Property• Motion to Fix Bar Date for Filing Claims• Proofs of Claim Prepared and Filed



Before Day 120 (Unless the Time is Extended, Which Usually Happens)

• Debtor Files a Plan and Disclosure Statement

After the Plan is Filed• Approval of Disclosure Statement• Solicitation of Acceptances from Creditors• Confirmation of Plan• Consummation of Plan


What Are the Key Factors That Will Impact Equipment Lessors?

The Automatic Stay and Section 1110/Section 1168• Stay Covers Debtor’s Property Wherever Located –

Worldwide Reach• Stay Covers Property in the Possession of the Debtor –

Leased Equipment• Generally, Stay Applies Unless Court Grants Relief



• Section 1110 (Aircraft Equipment and Vessels)

• Section 1168 (Railroad Rolling Stock Equipment)

• Airline / Water Carrier / Railroad Debtors Given 60 Days to make Deal



Section 1110(a)/1168(a) Agreements Extend Stay • May be Unilateral by Debtor – Agreement of

Lender/Lessor Not Required• Debtor Must Cure All Defaults• Debtor Must Agree to Perform All Obligations Under the

Contract • Court Approval Required• Not an Assumption of the Contract


Section 1110(b)/1168(b) Stipulations Extend the 1110/1168 Period

• Requires Agreement of Lender/Lessor• Extends 60-Day 1110 Period on Whatever Terms Agreed• Court Approval Required




Debtor May Later Breach or Reject Contract• Damages for Breach on Rejection• Administrative Claim Priority for Post-Petition Damages• Adequate Protection for Post-Petition Use of Equipment• Maintenance and Return Conditions



• “Surrender and Return” –Section 1110(c)/1168(c)• Use of Maintenance Reserves and Security

Deposits



Assumption or Rejection of ExecutoryContracts and Leases (Section 365)

Assumption Requires the Debtor to:• Cure All Defaults• Provide Compensation for Actual Pecuniary Losses

from Defaults• Provide Adequate Assurance of Future Performance



Damages for Breach of an Assumed Contract –Admin Claim Priority

Rejection of a Contract or Lease• Deemed Breach as of the Petition Date• Damages for Breach on Rejection – General Unsecured

Claim



Section 365(d)(10) – Debtor Required to Perform All Lease Obligations Arising from 60 Days After Filing Until Lease Assumed or Rejected

Adequate Protection for Post-Petition Use of Equipment


Who Is In Control – Debt or Equity?• What Consents Are Required For Deal Restructure?• Lender Issue: Foreclose Equity or Not?• Equity Issue: Hang In (At What Cost?) Or Walk

Away?• Equity Squeeze Protection – Can Lender

Foreclose?



Rejection or Modification of Collective Bargaining AgreementsInterim Changes to Collective Bargaining Agreements

The Other Factor Affecting Your Debtor – Labor Negotiations



Prerequisites to Rejection or Modification:• Debtor Proposal to Union

– Modifications Necessary to Permit Reorganization– Fair and Equitable Treatment of All Affected Parties

• Debtor Must Provide Information Necessary to Evaluate Proposal

• Debtor and Union Must Meet and Confer in Good Faith• Court Must Find That:

– Union Refused to Accept Proposal Without Good Cause– Balance of Equities Clearly Favors Rejection of CBA



Timing:• Hearing Within 14 Days After Application to Reject• Ruling Within 30 Days After Hearing (May Be

Extended)• If No Ruling Within 30 Days (or Extended Time),

Debtor May Terminate or Alter Terms of CBA Pending Ruling



Interim Changes to Collective Bargaining Agreements

• To Avoid Irreparable Damage, Court May Authorize Interim Changes in Terms, Conditions, Wages, Benefits or Work Rules Under CBA

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B. SUMMARY OF A DEBTOR’S DUTIES IN CHAPTER 11.

The provisions of the Code, Bankruptcy Rule 2015, and the U.S. Trustee’s Operating Guidelines and Reporting Requirements for Debtors-in-Possession impose a number of duties on the Debtor, although many of the administrative requirements included in the U.S. Trustee’s Guidelines will be modified or waived in by the court in larger cases. Absent a court order to the contrary, the Debtor will be required to:

(a) Appear and submit to an examination at a meeting of the creditors (Sections 341 and 343);

(b) File with the court a list of all creditors and a separate list of the twenty largest unsecured creditors and, unless the court orders otherwise, a schedule of assets and liabilities, a schedule of current income and current expenditures, and a statement of the corporation’s financial affairs (Section 521(1));

(c) Close the Debtor’s books and records as of the date of the filing of the petition and open a new set of books and records as of that date;

(d) Close the Debtor’s bank accounts as of the date of the filing of the petition;

(e) Open general, payroll and tax accounts for the post-petition operations of the debtor in possession;

(f) Within ten (10) days of the filing of the petition, provide the U.S. Trustee the following:

(1) a sworn statement verifying the closing of all pre-petition bank accounts and describing all new accounts;

(2) proof of insurance coverage; and

(3) copies of the Debtor’s most recent audited and unaudited financial statements;

(g) Within thirty (30) days of the filing of the petition, file returns for, but not pay, all pre-petition taxes, including sales taxes;

(h) Within thirty (30) days of the filing of the petition, provide the U.S. Trustee the following:

(1) copies of tax returns; (2) a physical inventory of Debtor’s property valued at cost; and

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(3) a current rent roll if tenant-occupied property is owned;

(i) File monthly reports on the form specified by the U.S. Trustee’s office by the twentieth day of the month following the month reported on;

(j) Pay quarterly fees to the U.S. Trustee in accordance with the U.S. Trustee’s instructions;

(k) Be accountable for all property received (Section 704(2));

(l) Examine proofs of claim and object to the allowance of any claim that is improper (Section 704(5));

(m) Furnish information concerning the estate and the estate’s administration as requested by a party in interest (Section 704(7)) (a “party in interest” may include the Debtor, a creditors’ committee, a creditor, an equity security holders’ committee, an equity security holder, or any indenture trustee (Section 1109(b));

(n) File with the court, the U.S. Trustee, and with any governmental unit charged with responsibility for collection or determination of any tax arising out of the operation of the business, periodic reports and summaries of the operation of the business, including a statement of receipts and disbursements, and such other information as the court or the U.S. Trustee requires (Section 704(8));

(o) File a plan of reorganization (Section 1106(a)(5));

(p) For any year for which the Debtor has not filed a tax return, furnish such available information as may be required by the governmental unit with which such tax return was to be filed (Section 1106(a)(6));

(q) After confirmation of a plan, file such reports as are necessary or as the court orders (Section 1106(a)(7));

(r) Make a final report and file a final account of the administration of the estate with the court and the U.S. Trustee (Section 704(9)).

II. THE PLAYERS

A. THE DEBTOR (Bankruptcy Rule 9001(5)).

For the performance of bankruptcy-related duties generally, (A) if the debtor is a corporation, “debtor” includes, if designated by the court, any or all of its officers, members of its board of directors or trustees or of a similar controlling body, a controlling stockholder or member, or any other person in control, and (B) if the debtor is a partnership, “debtor” includes any or all of

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its general partners or, if designated by the court, any other person in control.

B. THE BANKRUPTCY COURT.

The same bankruptcy judge will usually preside over all aspects of the case. Some, but not all, of his rulings may be appealed to the district court or court of appeals. It is important that the Debtor’s representatives establish themselves before the judge as honest, knowledgeable in their assigned areas, and competent.

C. COMMITTEES (Sections 1102-1103).

The Code requires the appointment of at least one creditors’ committee whose membership shall be limited to unsecured creditors. If more committees are required for adequate representation, the judge may appoint additional committees of creditors, equity security holders, or such special interest groups as employees or tort victims. The holders of the seven largest claims of the kinds represented by the committee will ordinarily be appointed to the committee.

The pertinent powers and duties of the committees are as follows:

(a) The committees may confer with the Debtor regarding the administration of the case;

(b) The committees may advise the court on the need for a trustee or examiner to be appointed; and

(c) The committees may investigate matters such as the acts, conduct, assets, liabilities and financial condition of the Debtor where no trustee has been appointed.

D. COUNSEL AND OTHER PROFESSIONALS (Sections 327-331).

The Debtor, all court appointed committees, and most other parties in interest, will be represented by counsel. The court must approve appointment of counsel for the debtor and court appointed committees. On request, the court may approve appointment of accountants, appraisers, and other professionals as well. Fees and expenses of appointed professionals are charged as costs of administration of the case after court review and approval.

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E. THE UNITED STATES TRUSTEE.

The United States Trustee oversees the administration of Chapter 11 cases. The Debtor and Debtor’s counsel must keep the U.S. Trustee apprised of significant matters affecting the case. Failure to comply with the requirements of the U.S. Trustee may result in a motion to dismiss the case, for the appointment of a trustee or examiner or for the imposition of other sanctions. A summary of the U.S. Trustee’s requirements is included in Paragraph I.B. above.

III. BENEFITS

A. THE AUTOMATIC STAY (Section 362).

The filing of the petition triggers an automatic stay against acts by creditors to collect their pre-petition debts. Lien enforcement, foreclosures and judicial, administrative, and other proceedings against the debtor are stayed, as are most other actions regarding pre-petition claims against the debtor or its property.

There are, however, limitations on the scope of the automatic stay. Governmental enforcement of regulatory and criminal actions will normally be unaffected by the stay, although they may still be enjoined by the Bankruptcy Court under its injunctive powers (Section 105). Thus, environmental controls, commerce acts, labor regulations and safety requirements are generally not stayed. Similarly, reports to the Securities and Exchange Commission or other reports and filings with governmental agencies are still required.

B. RIGHT TO REMAIN AS DEBTOR IN POSSESSION AND OPERATE BUSINESS (Sections 1107, 1108, 1104).

When a Chapter 11 case is filed, the Debtor will normally continue to operate its business as debtor in possession. It is not necessary to go to court to obtain an order authorizing continued operation of the business, and a trustee is not normally appointed. As debtor in possession, the debtor has most of the rights and powers, and is required to perform most of the functions and duties, of a trustee serving in a Chapter 11 case. The powers thus conferred on the debtor in possession include even the trustee’s powers to avoid pre-petition transfers of property under Sections 544, 547 and 548 and to avoid the fixing of certain statutory liens under Section 545.

C. UTILITIES (Section 366).

The Code provides that utility service may not be terminated due to failure to pay pre-petition debts. Utility companies may, however, discontinue service

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within 20 days after the petition is filed if they do not receive from the Debtor adequate assurance of payment for service performed after such date. Such adequate assurance may be in the form of a deposit or other security, and, upon request by a party in interest (such as the Debtor) and after notice and a hearing, the judge may modify the amount of the deposit or other security posted as adequate assurance.

Section 366 applies to all creditors holding a monopoly in an area so that the Debtor cannot easily obtain comparable service. This includes such utilities as electric, gas, water, sewage and telephone service and, in appropriate cases, even airlines or airports or other similar services.

D. PROTECTION AGAINST DISCRIMINATORY TREATMENT (Section 525).

Except as provided in certain federal acts, a governmental unit may not deny, revoke, suspend or refuse to renew a license, permit, charter, franchise or other similar grant to, condition such a grant to, discriminate with respect to such a grant against, deny employment to, terminate the employment of, or discriminate with respect to employment against, a person that is or has been a Debtor or another person with whom the Debtor has been associated, solely because of the Debtor’s insolvency or the filing of the Chapter 11 petition.

III. DUTIES

A. APPEARANCES.

1. Creditors’ Meeting (Section 341)

The Code requires a meeting of the creditors not less that 20 nor more than 40 days after the petition is filed. The judge will not be present; the U.S. Trustee will preside at the meeting. The business of the meeting will include the examination of the Debtor by the U.S. Trustee and the creditors. The U.S. Trustee may also request a meeting with the Debtor and its counsel prior to the creditors’ meeting.

2. Bankruptcy Rule 2004 Examinations

On motion of a party in interest, the court may order examination of any person covering the acts, conduct, property, liabilities, business and financial condition of the Debtor and the Debtor’s reorganization plan. These examinations usually take place at a party’s or counsel’s office, and are similar to depositions in civil litigation. Only the parties, counsel, and a court reporter will normally be present.

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3. Hearings

During the case the court may schedule hearings to decide matters at issue before the court such as requests to use cash collateral, motions for relief from automatic stay, and confirmation of the reorganization plan. The Debtor may normally present evidence at such hearings through live testimony from appropriate officers, employees or other witnesses.

B. FILINGS.

1. Notice Requirements of the United States Trustee

The office of the United States Trustee has published a list of certain requirements which must be complied with at the time of, or within specified times following, the filing of a Chapter 11 case. As noted above, many of the U.S. Trustee’s administrative requirements may be modified or waived by the court in larger cases.

2. Schedules (Bankruptcy Rule 1007(b))

The Debtor must file with the court schedules of its assets, and a statement of the executory contracts, including unexpired leases, to which the Debtor is a party. Such schedules and statement must be filed within 15 days of the filing of the petition. Extension of time for filing will be granted only for cause shown and on notice to any creditors’ committee, examiner or other party as the court may direct.

3. Required Records, Reports and Notices (Bankruptcy Rule 2015)

The Debtor, when acting as debtor in possession, shall (1) file a complete inventory of the property of the Debtor within 30 days after qualifying as debtor in possession, unless such an inventory has already been filed; (2) keep a record of receipts and the disposition of money and property received; (3) file the reports and summaries required by Section 704(8) within the times fixed by the court and which shall include a statement, if payments are made to employees, of the amounts of deductions for all taxes required to be withheld or paid for and in behalf of employees and the place where these amounts are deposited; (4) as soon as possible after the commencement of the case, give notice of the case to every entity known to be holding money or property subject to withdrawal or order of the Debtor, including every bank, savings or building and loan association, public utility company, and landlord with whom the Debtor has a deposit, and to every insurance company which has issued a policy having a cash surrender value payable to the Debtor, except that notice need not be given to any entity who has knowledge or has previously been notified of the case; (5) within 30 days after the date of the order confirming a plan or within such other time as the court may fix, file a

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report with the court concerning the action taken by the debtor in possession and the progress made in the consummation of the plan and file further reports as the court may direct until the plan has been consummated; and (7) after consummation of a plan, file an application for a final decree showing that the plan has been consummated, and the names and addresses, if known, of the holders of claims or interests which have not been surrendered or released in accordance with the provisions of the plan and the nature and amounts of claims or interests, and other facts as may be necessary to enable the court to pass on the provisions to be included in the final decree.

4. Monthly Reports

The books of the Debtor should be closed and reopened as of the date of the filing of the Chapter 11 petition. Thus, the filing of the petition initiates a new operation for accounting purposes. Thereafter, during the course of the Chapter 11 case, the Debtor is required to file with the Court monthly reports and summaries of the operation of the business, including a statement of receipts and disbursements, and such other information as requested on the U.S. Trustee’s form. Counsel should be consulted with respect to the contents and frequency of reports required by other governmental entities.

5. Taxes

Although taxes which accrue before the filing of the petition are priority claims, they should not be paid except on order of the court or pursuant to the reorganization plan; all taxes which accrue after the date of filing, however, must be paid when due. Federal, state and local tax returns must be filed, and FICA and withholding taxes, sales taxes and similar levies should be escrowed as collected and deposited as required by the taxing authorities. Under no circumstances should expenditures exceed receipts without paying all post-petition taxes. Counsel or the special procedure staff of the taxing authorities should be consulted to insure that proper procedures are being followed with respect to payment of all appropriate taxes.

C. RUNNING THE BUSINESS IN BANKRUPTCY.

1. Use, Sale and Lease of Assets (Section 363)

In order to keep the business in operation, the Debtor may use, sell or lease property of the estate. This authority, however, is subject to the following limitations:

(a) The Debtor may enter into transactions that are in “the ordinary course of business” except:

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(1) The court may impose limitations where necessary to provide adequate protection to the interests of creditors;

(2) The Debtor may not use, sell or lease “cash collateral” unless creditors with an interest in that collateral consent or the court authorizes such use after notice and a hearing. “Cash collateral” means cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents in which the estate and an entity other than the estate have an interest, such as a lien or a co-ownership interest. Proceeds of “non-cash” collateral still subject to the original lien on the property are included within the definition of cash collateral;

(b) The Debtor may also use, sell or lease property outside the ordinary course of business, but only upon court order after notice and a hearing.

(c) The Debtor may, under special circumstances, sell property free and clear of any encumbrance. In such a case, secured creditors can bid at the sale and offset the full amount of the debt owed them, and co-owners have a right of first refusal at the price at which the sale is to be consummated.

2. Obtaining Credit to Operate the Business (Section 364)

The Debtor must usually obtain credit and incur debt to continue operation of the business. Provisions for obtaining credit under the Code are as follows:

(a) The Debtor may obtain unsecured credit and incur unsecured debt in the ordinary course of business, subject to limitations that may be imposed by the court. Debts so incurred are granted a priority as administrative expenses under Sections 503(b)(1) and 507(a)(1);

(b) The court may authorize the Debtor to obtain unsecured credit or incur unsecured debt other than in the ordinary course of business after notice and a hearing. Debts so incurred are likewise granted an administrative expense priority;

(c) When unsecured credit is not available, the court, after notice and a hearing, may authorize the Debtor to obtain credit or incur debt by providing the post-petition creditor with a priority over all administrative expenses, a lien on unencumbered property of the estate, or a junior lien on the encumbered property of the estate;

(d) When all else fails, the court has authority to authorize the obtaining of credit or incurring of debt secured by a lien on encumbered property senior or equal to the existing lien on the property. This is called a “superiority lien”. It may only occur when the Debtor is otherwise unable to obtain credit

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and only if there is adequate protection of the original lienholder’s interest. The Debtor has the burden of proof on the issue of adequate protection.

3. Executory Contracts and Leases (Section 365)

A Debtor may “assume” or “reject” executory contracts, including unexpired leases. “Assumption” means performance of the contract or lease according to its terms, except that (i) the Debtor must cure all defaults, (ii) the Debtor must provide adequate assurance of future performance, and (iii) the Debtor may usually assign the contract or lease under certain circumstances, notwithstanding any provisions in the agreement to the contrary.

“Rejection” means a breach of the contract or lease, and the non-debtor party is usually given a claim for damages arising from such rejection as if it occurred just before the commencement of the case.

The Debtor may usually decide to assume or reject an executory contract or lease at any time prior to confirmation of the reorganization plan, unless a party to such contract or lease requests the court to order the Debtor to do so earlier. In addition, the Code expressly provides that clauses which prohibit assignment or automatically terminate a contract or lease upon insolvency or filing of bankruptcy are not enforceable in a bankruptcy case. Some contracts, such as a contract to make a loan to the Debtor, may not be assumed.

Leases of non-residential real property are subject to strict rules of assumption or rejection. First, the lease is deemed rejected unless the Debtor moves to assume it in the first 60 days of the case, or within an extension of that period. Second, the Debtor must fulfill its post petition obligations under the non-residential real property lease until the lease is assumed or rejected, whether it actually uses the property or not. Third, the court may not approve assignment of some leases unless the assignee meets certain financial standards.

4. The Reorganization Plan (Sections 1121-1124)

The Debtor may file a reorganization plan with the petition commencing the voluntary bankruptcy case, and if the Debtor continues in possession, it has the exclusive right to file a plan for the first 120 days after the filing of the petition. Once a Debtor files a plan during the 120 day period, no other party may file a plan unless the Debtor’s plan has not been accepted within 180 days of the filing of the petition. Upon expiration of these “exclusive” periods or any extensions the court may grant, a proposed plan may be filed by the Debtor, a creditors’ committee, an equity security holders’ committee, a creditor, an equity security holder, or any indenture trustee.

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(a) Required Provisions. Section 1123 requires that a plan must:

(1) Designate classes of claims in interest other than certain priority claims (such as income and property taxes, administrative expenses and other claims under Section 507, which need not be classified);

(2) Specify classes whose claims or interests are not impaired by the plan. A claim has not been impaired by the plan if the legal rights of the holder of the claim have not been altered or if the holder of the claim receives cash or property equal to the amount of the claim;

(3) Specify the treatment of classes whose claims or interests are impaired. A claim or interest is impaired by the plan when the holder is not fully compensated for damages incurred as a result of a reasonable reliance on a contractual provision or an applicable law;

(4) Provide the same treatment to all claims or interests within a particular class;

(5) Provide adequate means to implement the plan;

(6) Provide for necessary amendments to the corporate Debtor’s charter to prohibit issuance of non-voting securities and to assure an equitable distribution of voting power; and

(7) Contain equitable provisions with respect to the selection of officers, directors or trustees of the Debtor.

(b) Permitted Provisions. A plan may also, but is not required to:

(1) Impair or leave unimpaired classes of claims or interests;

(2) Provide for the assumption, rejection or assignment of executory contracts and leases;

(3) Provide for the settlement of any claim or interest held by the Debtor;

(4) Provide for the sale of all or substantially all of the Debtor’s property; and

(5) Include any other provisions not inconsistent with the Code.

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D. OTHER DUTIES.

1. Money of the Estate: Deposit and Disbursement (Section 345)

The withdrawal or disbursement of money of the estate may only be by check or other method approved by the court. The Debtor must close out all corporate books and accounts as of the date of filing of the petition and open new books as of that date. The Debtor must open at least three new bank accounts in one or more authorized depositories (FDIC insured), and the checks for each must bear the words “Debtor in possession” and the bankruptcy case number:

(a) The Debtor must open an operating account in the name of the Debtor and styled “Debtor in possession Operating Account.” All receipts or collections must be deposited in this account.

(b) The Debtor must open an account in the name of the Debtor and styled “Debtor in possession Tax Account.” The Debtor should deposit in this account all monies being withheld from employees, all tax funds owed by the Debtor arising from the employment of personnel, and other taxes collected for others or due under any law of the United States or any State.

(c) The Debtor must open an account in the name of the Debtor and styled “Debtor in possession Payroll Account.” The Debtor should deposit in this account all monies to be paid as wages or salaries to officers and employees.

(d) If the Debtor is permitted to use “cash collateral”, the Debtor may be required to maintain separate “cash collateral” accounts.

(e) The Debtor may also deposit or invest money of the estate in the manner that will yield the maximum reasonable net return of the money while providing for the safety of the deposit or investment. The Debtor may make deposits in savings and loans, purchase government bonds, or make such other deposits or investments as are authorized under Section 345. Any interest or gains realized from these deposits or investments become property of the estate. Before making any such investments, however, the Debtor should consult with counsel to ensure that such investments or deposits are properly authorized.

2. Prosecution or Defense of Lawsuits (Bankruptcy Rule 6009)

The Debtor may, with or without court approval, prosecute or enter an appearance and defend any pending action or proceeding by or against the Debtor, or commence and prosecute any action or proceeding on behalf of the

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estate before any tribunal. As in every other instance, however, if actions or expenditures by the Debtor are called into question, the ultimate burden will be with the Debtor to satisfy the court that such actions or expenditures were necessary and in the best interest of the estate.

3. Debtor’s Fiduciary Responsibilities

Upon the filing of a Chapter 11 petition, as part of the “price” the Debtor pays for the protection afforded by the Code, the Debtor assumes a fiduciary responsibility towards its creditors and with respect to its own property. At a minimum, this fiduciary responsibility requires the Debtor and its representatives to be strictly accountable for all property and monies and to act in the best interests of the creditors rather than necessarily or exclusively in the best interests of the Debtor.

(a) Safeguarding Assets. The Debtor is expected to take appropriate action to protect the assets of the company from destruction or post-petition claims. For example, it is the obligation of the Debtor to insure that adequate casualty and liability insurance are maintained so that risk to, and diminution of, the bankruptcy estate can be avoided. The Debtor must provide proof of appropriate insurance to the U.S. Trustee.

The following types of insurance are mandatory to the extent applicable:

(1) automobile (all types) (for example, Local Rule 4 of the United States Bankruptcy Court for the Northern District of Georgia requires a debtor possessing an uninsured vehicle that is collateral securing indebtedness to obtain full collision and comprehensive insurance within 72 hours after a request by the secured creditor);

(2) fire, theft, casualty and natural disaster (as available); (3) general comprehensive liability;

(4) unemployment and workers’ compensation (as required by state law);

(5) product liability; and

(6) such other insurance as is required reasonably to protect against loss of assets or liability for damages.

The following types of insurance are usually permissible, although not required:

(1) umbrella liability;

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(2) accounts receivable and bad debt;

(3) employee health, hospital, accident, etc.;

(4) business interruption; and

(5) director and officer liability.

(b) Exercise of Sound Business Judgment. As a fiduciary, the Debtor, when acting as debtor in possession, is obligated to exercise sound business judgment to minimize expenses, to avoid unnecessary or improper payments from or transfers of property of the estate and to act only in compliance with the Code and within the authority granted therein to the Debtor. Officers of the Debtor who act, or who permit the Debtor to act, in violation of the Code or the fiduciary duties imposed thereunder may be held personally liable to the estate for such improper conduct. In addition, any transaction appearing to be motivated by other than good business judgment, or otherwise appearing improper, may be grounds for the appointment of a trustee or the dismissal or conversion of the Chapter 11 case to straight bankruptcy.

The following transactions are not ordinarily permitted under any circumstances:

(1) giving gifts to anyone (including to charities or to employees);

(2) making any transfer for other than material, fair equivalent consideration;

(3) engaging in speculative activities outside the ordinary course of business;

(4) paying any pre-petition unsecured indebtedness other than pursuant to the reorganization plan.

The following transactions may only be made with court approval, after notice to all creditors and other parties in interest:

(1) the sale of any property of the Debtor other than in the ordinary course of business;

(2) any compromise or settlement of a lawsuit or other controversy;

(3) any payment to attorneys, accountants or other professionals retained by the Debtor;

(4) any use of cash which is collateral for any secured obligation of the Debtor;

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(5) the obtaining of any credit or incurring of any debt other than in the ordinary course of business or the granting of any security interest in property of the estate to obtain credit or incur debt, whether in the ordinary course of business or otherwise.

(c) Actions With or for the Benefit of “Insiders”. All transactions with insiders are inherently suspect even though such transactions may be in connection with the Debtor’s business. An insider transaction is a business dealing, whether company or personal, between the Debtor and an “insider” as defined in the Code. With respect to a corporate debtor, “insider” means any officer, director or person in control of the Debtor, any partnership in which the Debtor is a general partner, any general partner of the Debtor, and any relative of a general partner, director, officer or person in control of the Debtor. In addition, transactions with, or for the benefit of employees of and professionals (i.e. attorneys, accountants, etc.) retained by the Debtor are also suspect. Counsel should be consulted before any transaction is undertaken which benefits or appears to benefit an insider, such as transfer of property to or for the benefit of an insider or the diversion of any business or business opportunity to an insider or an entity controlled by an insider.

IV. LIABILITIES

A. CIVIL LIABILITY.

The Debtor, when acting as debtor in possession, may be sued, without leave of court, with respect to any acts or transactions in carrying on business connected with the property of the estate. Thus, the Debtor is subject to civil liability on any contracts entered into and for any negligence on the part of the company or its agents occurring after the filing of the petition, and the Debtor is bound by the laws of any state in which it owns property or does business in the same manner as if the Chapter 11 proceeding were not pending. See 28 U.S.C. § 959.

B. CRIMINAL LIABILITY.

Under federal law, certain acts with regard to estates being administered in any bankruptcy court are federal crimes. In particular, it should be noted that it is a criminal offense to conceal or destroy any books and records relating to the property or financial affairs of the Debtor. See 18 U.S.C. §§ 151-155, 3057 and 3284.

ATL1 #573724 v1

LESSOR DAMAGES AND MITIGATION

By William B. Piels, Partner

HOLLAND & KNIGHT LLP

EQUIPMENT LEASING ASSOCIATION

2003 LARGE TICKET CONFERENCE

April 27-29, 2003

I. Introduction

Various commentators have referred to the effort to measure the damages recoverable by

a lessor following breach of a lease by the lessee as "frustrating", "confusing" and

"inconsistent."1 Nevertheless, the principles applicable to both the measure of damages and

required mitigation in the instance of such a breach are not particularly difficult to articulate or

understand. Put most directly: a lessor should be entitled to a recovery that places it in the same

position as the lessee's performance would have placed it in, but should not be permitted to

recover for losses that the lessor could reasonably have avoided. Judicial attempts to apply these

principles have met with mixed success at best, with some courts showing obvious confusion

over the nature and economics of the bargain struck between the lessor and the lessee.2

The adoption of Article 2A of the Uniform Commercial Code3 by nearly all jurisdictions4

has resulted in a relatively cohesive and understandable framework for the analysis of the issues

that arise in this context.5 While Article 2A's damage calculation provisions may not be applied

directly, because they are written just to apply when the lease agreement is silent (never the case)

or when the lease agreement's damage calculation is unenforceable, those provisions still

establish a standard against which lease agreement's damage calculation provisions will be

1 B. Marks, 2 Equipment Leasing, Ch. 16 "Equipment Lease Defaults: Calculating the Lessor's Damages", 16-2 (Wong ed., 2002); A. Reisman and C. Mooney, Jr., 1 Equipment Leasing - Leveraged Leasing Ch. 1 "Drafting, Negotiating and Construing the Equipment Lease --An Overview", p.80 (Fritch et al. eds., 3rd ed. 1988).

2 See, R. Strauss, "Equipment Leases Under UCC Article 2A: Analysis and Practice Suggestions", (PLI 1993) at 74 (outlining six fairly substantial court errors ranging from formulations that provided clear windfalls to the lessor to formulations that unfairly penalize the lessor). See also, Potomac Leasing Company v. Blue Chip Express, Inc., 514 N.E.2d 956 (Ohio C.P. 1986) (after concluding that a lessor should not be entitled to both accelerated rents and possession of the leased property, the court laments that the principles applicable to calculating lease damages have not been fully explored in law reviews).

3 References herein are to Official Text Article 2A - Personal Property Leases, incorporating the amendments promulgated by the American Law Institute and the National Conference of Commissioners on Uniform State Laws in 1990.

4 Article 2A has been adopted in all states other than Louisiana.

5 Article 2A provides damage formulae in circumstances where the lessor has recovered and relet the property under a leasing arrangement that is "substantially similar" to the defaulted lease (U.C.C. §2A-527); where the lessor has recovered the leased property but either has not relet or the releasing transaction is not "substantially similar" to the defaulted lease (U.C.C. §2A-528); and where the lessee has retained possession of the leased property (U.C.C. §2A-529). In addition, Article 2A addresses recovery of a lessor's incidental damages (U.C.C. §2A-530) and recovery for any damage to the lessor's residual interest in the lease property (U.C.C. §2A-532).

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judged. The confusion and lack of consistency which existed in pre-Article 2A case law

concerning lessor damages and mitigation are being reconciled as more cases are being decided

under the provisions of Article 2A.

This paper will: (i) examine the elements of loss that may be included in calculating the

gross amount of damages incurred by a lessor as a consequence of the lessee's breach; (ii)

consider application of the principles of mitigation to calculating the lessor's damages; and (iii)

consider liquidated damages provisions.

II. Elements Comprising Lessor Damages

It seems difficult to argue with the proposition that calculation of a lessor's damages

ought to include every element of loss required to place the lessor in the same position as it

would have been had the lessee fully performed its obligations under the lease agreement. In

essence, the amount calculated as damages ought to "make the lessor whole," without awarding

any windfall or leaving the lessor with any shortfall. With this principle in mind, each of the

following elements of loss merits consideration.

A. Costs of Enforcement

Unless the lessor is entitled to recover its costs of enforcement, it cannot be

placed in the same position that the lessee's performance would have placed it in. Thus, the cost

of enforcement is a necessary element in the calculation of the lessor's damages. Article 2A does

not provide a statutory right for recovering attorneys' fees and the rules vary from state to state as

to whether such a recovery is favored or disfavored.6 In any case, the lease agreement should

specify attorneys' fees as a recoverable element of damages for the lessor.7

B. Incidental Damages

The lessor will also incur costs in storing and maintaining the aircraft and,

depending upon its condition, and disposition, readying the aircraft for sale or release. To the

extent that these costs would not have been incurred but for the lessee's default, they form

another component of damages that the lessor must be entitled to receive in order to be placed in

6 See Marks, n.1 supra; at 16-11.

7 In some states, specifying that either party is entitled to recover attorney's fees means that the prevailing has such right. See, e.g., Cal CC §1717; EDS Corporation v. W.A. Foote Memorial Hospital, Inc., 25 F.3d 406 (6th Cir. 1994).

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the same position as if the lessee had performed. Article 2A provides a statutory right to recover

these types of "incidental" damages provided that they are "commercially reasonable”.8

In the case of expenses incurred to ready the aircraft for a re-leasing transaction,

there may, of course, be many expenses attributable to the follow-on transaction that will be

difficult to characterize in this regard. One example is the cost of transitioning an aircraft to a

new lessee's maintenance program. Such costs are not reflective of any failure in satisfying

maintenance obligations of the defaulting lessee, but instead are a consequence of differences

between the maintenance program of the old operator and the maintenance program of the new

operator. Since these costs would be incurred by the lessor even if the lessee had returned the

aircraft at termination of the lease without having committed any breach whatsoever, one could

argue that denying the lessor recovery of these amounts does not prejudice its position.

However, such a view ignores the fact that the transition costs are incurred in connection with a

lessor's attempt to mitigate damages. Since, as discussed below, the amount of the lessor's

recovery will be reduced by the proceeds of the re-leasing transaction, failing to count these

types of costs as an element of damages would result in the lessor receiving a net aggregate

recovery that is less than what would have been received had the lessee performed its obligations

under the lease.

C. Past Due Amounts

Obviously, the lessor cannot be made whole unless it is entitled to recover all

amounts that have become due under the lease.9 In addition, the lessor must receive interest on

past due amounts in order to account for the time value of money.10 While these amounts do not

seem subject to controversy as legitimate elements of a lessor's damages, they may become so in

the context of mitigation, as discussed below.

8 U.C.C. §2A-530.

9 The various damage formulae provided by Article 2A are conceptually consistent with this treatment. In a case where the lessee retains possession of the leased property, accrued and unpaid rent is payable through the date of judgment. U.C.C. §2A-529. In the cases where the lessee does not retain possession of the leased property, accrued and unpaid rent is recoverable through the commencement date of a "substantially similar lease" for the property, if one is entered into, or through the date that the lessor recovers possession or the lessee tenders possession back to the lessor, if the property is not re-let under a "substantially similar lease". U.C.C. §2A-527 and U.C.C. §2A-528.

10 Article 2A does not provide for recovery of interest on past due amounts.

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D. Damage To Residual Interest

If the lessee's breach has resulted in a diminution of the value of the aircraft, the

lessor must be entitled to recover compensation for that diminution in order to be made whole.11

Nevertheless, the complex nature of an aircraft can make this recovery difficult to calculate. For

example, suppose the lease agreement provides that the aircraft must be returned with at least

half of the "D" check interval remaining unexpired and with the engines having no less than

some set minimum number of hours and cycles remaining to overhaul at the time of return. If

the aircraft does not satisfy these conditions at the time of return, should the measure of damages

be the entire cost of an overhaul or should the lessee receive some credit based on the time

remaining? Arguments can be made for either position. In this hypothetical, the lessor and

lessee bargained for such return conditions as genuine minimum physical requirements.

Permitting the lessee to substitute for that bargain the payment of an amount representing just the

portion of the cost of an overhaul that equates to the deficiency in return conditions would

substantially rewrite that bargain. On the other hand, charging the lessee for the entire cost of an

overhaul would seem to do more than make the lessor whole. The problem, of course, stems

from the fact that it is impractical or impossible to perform just enough of the required overhauls

to bring the engines and airframe into compliance with the lease. Theoretically, a payment to the

lessor in an amount equaling the difference between the value of the aircraft in the condition

returned and the value that the aircraft would have had if it met the return conditions would make

the lessor whole. Unfortunately, calculating such a differential with any degree of certainty may

be quite difficult.

E. Future Rents

The lessor will not be made whole unless it receives the economic equivalent of

the unpaid rent for the unexpired portion of the lease. There is no doubt that such a payment will

overcompensate the lessor unless it is discounted to present value to take account of the time

value of money. If the lease fails to require a present value calculation, it is likely that such

discounting will be required for enforcement and the court may select a discount rate that is

substantially different from what the lessor and lessee would have agreed upon.12 Under

11 See U.C.C. §2A-532.

12 See, Kedziora v. Citicorp National Services, Inc.,780 F.Supp. 516 (N.D. Ill. 1991) (holding that a rent acceleration clause that neglected to reduce future rents to present value created an

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section 2A-103(21), the discount rate agreed upon by the parties will be upheld unless it is

"manifestly unreasonable."

F. Consequential Losses

A lessee's breach may result in the lessor losing substantial tax benefits, incurring

break funding costs and/or prepayment penalties or suffering other consequential losses. While

it is clear that recovery of these losses is required in order to place the lessor in the same position

it would have been in had the lessee fully performed its obligations, current law could impose

some obstacles to this result.

Article 1-106 of the Uniform Commercial Code provides that:

The remedies provided by this code shall be liberally administered to the end that the aggrieved party may be put in as good a position as if the other party had fully performed but neither consequential or special nor penal damages may be had except as specifically provided in this code or by other rule of law. [Emphasis added.]

While Article 2A provides that a lessee may recover consequential damages upon breach of a

lease by a lessor,13 it does not contain a counterpart provision for the benefit of a lessor.

However, section 2A-504, which is discussed below, specifically sanctions a liquidated damages

clause that includes indemnity for loss of tax benefits so long as the formulation is reasonable.

Should Article 2A be interpreted to preclude a lessor from recovering its consequential damages

even if the lease agreement specifically permits such a recovery? The analogous provisions of

Article 2 have generally been interpreted to preclude a seller from recovering consequential

unenforceable windfall in favor of the lessor); Frontier Leasing Corporation v. Griffin Petroleum Inc., 172 F.Supp.2d 1172 (S.D. Iowa 2001) (discounting accelerated rents to present value); CHR Equipment Financing, Inc. v. C & K Transport, Inc., 448 N.W.2d 693 (Iowa Ct.App. 1989) (discounting accelerated rents to present value); Heller Financial, Inc, v. Brian Burry, 633 F.Supp. 706 (N. D. Ill. 1986) (discounting accelerated rents to present value); and In re Bruce Daly, 167 B.R. 932 (D.C. Mont. 1994) (discounting future rents by the interest rate applicable to late payments under the lease). While Article 2A expressly recognizes the use of present value calculations in determining the damages owed in respect of future rents, its not entirely clear under Article 2A that such a calculation is required. Compare Official Comment to U.C.C. §2A-103(21) to Official Comment to U.C.C. §2A-101 "Damages". But see, Emlee Equipment Leasing Corporation v. Waterbury Transmission, Inc., 626 A.2d 307 (Conn. App. Ct. 1993) (upholding a lease acceleration clause which failed to discount future rents to present value against a charge that such a clause was unconscionable).

13 See, U.C.C. §2A-520.

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damages.14 However, Article 2 does not contain the "freedom of contract" endorsement found in

section 2A-523, which enables a lessor to exercise any rights or remedies provided in the lease

agreement in addition to those provided in Article 2A. None of the reported cases interpreting

Article 2A to date have addressed this issue, but one would expect a lessor's contractual right to

recover consequential losses to be enforceable.15

III. Mitigation

As a general principle, the lessor's recovery of damages is limited to those elements of

loss which would not have been avoided by the lessor's reasonable efforts.16 This limitation on

recoverable damages is commonly referred to as a "duty to mitigate". In fact, the term "duty" is

a misnomer. The lessor owes no affirmative duty to the lessee to act in any particular way

following a lessee's breach, and a lessee has no right of action against a lessor who fails to

mitigate damages. Instead, mitigation acts as a limitation on the lessor's right of recovery,

regardless of the actions the lessor actually takes or fails to take following the breach, and is

perhaps better described as a doctrine of avoidable consequences.

The principle of mitigation is very straightforward. It limits the lessor's recovery to the

elements of damages that could not have been avoided had the lessor acted in a reasonable way

once the lessor realized that the lessee was in breach. However, application of mitigation

principles to a leasing transaction can present a number of questions.

A. Is Mitigation Waivable?

A common remedy provision permits the lessor, after taking possession of a

leased aircraft to sell it, lease it, or hold it idle. There is no question that the lessor, as the owner

of the aircraft, has the right, after repossession, to take whatever action it chooses. As noted

above, the "duty" to mitigate damages is a limitation on the right to recover for losses that could

have been avoided, not an affirmative duty to take some particular action. The lease provision

14 1 White and Summers, Uniform Commercial Code (West Fourth Edition 1995) at p. 412.

15 The subject of a lessor's right to recover consequential damages is being addressed in amendments to Article 2A which are being considered in connection with amendments to the corresponding provisions of Article 2.

16 See 1 Charles L. Knapp, Commercial Damages, Ch.4 "Mitigation of Damages: The Doctrine of Avoidable Consequences" (Mathew Bender 2002) (discussing general principles of mitigation in a variety of contexts, including leases).

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permitting the lessor to "hold idle" an aircraft is probably best interpreted as an expression of the

lessor's authority to decide how to deal with its assets.

Would a clear waiver by the lessee of any obligation on the part of the lessor to

mitigate damages following a breach by a lessee be enforceable? While numerous cases address

the question of mitigation, the enforceability of a lease provision purporting to waive a

mitigation limit on damages has seldom been addressed.17 In considering the enforceability of

such a waiver, it would be important to recognize the difference between an acknowledgment

that the facts and circumstances of the leasing transaction make the doctrine of mitigation

inapplicable, which is the circumstance discussed in the following section, and a waiver of the

mitigation limit when the principles of mitigation would otherwise apply. The waiver of the

mitigation limit brings into direct conflict the policy of the Uniform Commercial Code with

respect to damages, as expressed in Section 1-106, with the freedom of contract principles

embodied in Article 2A As a matter of policy, the better view would seem to favor making such

a waiver unenforceable.

B. Is Mitigation Always Applicable?

Since mitigation acts as a limit on recovery of damages which the lessor could

have avoided, it seems clear that there will be circumstances when the doctrine simply does not

apply. For example, suppose the case of an operating lessor who, already having in storage

several DC-10 aircraft, takes possession of an additional DC-10 from a defaulting lessee. If the

lessor re-lets the repossessed DC-10 while its other DC-10's remain in storage, should the lessee

receive the benefit of the re-lease proceeds as a credit against the damages it would otherwise

owe for breach of the lease? The answer seems to turn on whether the re-leasing transaction was

made possible by the lessee's default and the lessor's repossession of this particular DC-10. Put

another way, if the lessor was in a position to enter into the re-letting transaction whether or not

the lessee defaulted, crediting the lessee with the re-letting proceeds will not leave the lessor in

the same position as it would have been in had the lessee performed.

The foregoing example illustrates the position of a "lost volume" lessor. The

concept is expressly recognized in Article 2A and has been applied by courts in cases decided

17 See Business Systems Leasing, Inc. v. Foothills Automotive Plaza, Inc., 886 F.2d 284 (10th

Cir. 1989) (upholding a lease clause which waived the lessor's duty to mitigate damages and stating that the court saw no barrier to upholding the parties' contractual agreement in this regard).

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before and after the adoption of Article 2A.18 In any factual setting, however, there is ample

room for disputing whether or not the lessor qualifies as a "lost volume" lessor.19 For example,

given the potential differences in like-model aircraft based on date of manufacture, operating

history, cabin configuration, prior maintenance program and maintenance condition, aircraft are

not readily likened to the more fungible types of property (e.g., jukeboxes and coin-operated

laundry machines) that "lost volume" analysis has been applied to in the case law. The selection

of a particular aircraft in a re-leasing transaction may, itself, indicate that some aspect of the

aircraft is uniquely attractive to the new lessee, supporting the position that if the default had not

occurred, the new transaction would not have been possible. While Article 2A does not specify

where the burden of proof lies on the "lost volume" issue, cases decided under the analogous

section of Article 2 place that burden on the seller.20 Thus it seems likely that the lessor will

have the burden of demonstrating this status.

While the foregoing example refers to an operating lessor who is dealing with

aircraft in inventory, a case can be made for applying "lost volume" status to a finance lessor as

well. The argument would be that the finance lessor acts simply as a source of money for the

18 See, The Corner v. Pinnacle, Inc., 907 P.2d 1281 (Wyo. 1995) (applying U.C.C. §2A-528(b) to hold that the lessor of a jukebox need not apply rents from a re-letting transaction to reduce the amounts recoverable from the breaching lessee); Jetz Service Co., Inc. v. Salina Properties, 865 P.2d 1051 (C.A. Kan. 1993) (applying "lost volume" lessor status to a lessor of coin-operated laundry equipment); Seaboard Music Co. v. Germano, 24 Cal.App.3d 618 (C.A. Cal. 1972) (applying "lost volume" status to a jukebox lessor); Shoreline Communications Inc. v Norwich Taxi, LLC, No. 554717 2001 Conn. Super. LEXIS 1111 (Conn. Super. 2001) (applying "lost volume" status to rental space on a three-hundred-foot transmitter tower); and Steen Industries Inc. v. Richer Communications, Inc., 314 A.2d 319 (Sup.Ct. of Pa. 1973) (holding that billboards are not the type of property to which "lost volume" analysis can be applied). But see, Acme Music & Vending, Inc. v. Bill's Place, Inc., No. 90-T-4500 1991 Ohio App. LEXIS 6385 (C.A. Oh. 1991) (holding that "lost volume" status could not be applied to a coin-operated vending machine lessor because the doctrine does not apply to a lease).

19 Courts have adopted a variety of tests to distinguish a "lost volume" seller from other sellers and should be expected to apply a similar analysis to lessors. One such test requires the party seeking "lost volume" status to establish that: (1) it possessed the capacity to make an additional sales; (2) it would have been profitable for it to make an additional sales; (3) it probably would have made an additional sale if the other party had not breached. See, In re El Paso Refinery, LP, 196 B.R.58 (Bankr. W.D. Tex. 1996); Knapp, supra, n.16 at p.4-31. Recently, the South Carolina Court of Appeals applied the "lost volume seller" analysis in calculating the lessor's damages in a breach of contract case where the lessor established that (i) it had the adequate inventory to place as many equipment as it could have found customers for and (ii) any additional deals would be "in addition to, rather than instead of" the breached transaction. Collins Entertainment Corp. v. Coats and Coats Rental Amusement, No. 3596 2003 S.C. App. LEXIS 17 (S.C. App. 2003).

20 Knapp, supra n.16 at 4-30.

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leasing transaction and that it has the ability to expand its business to meet the market.21 If the

finance lessor can demonstrate that it could have profitably arranged the re-leasing transaction

with another aircraft, it can make out a case that awarding the defaulting lessee with a credit in

mitigation for the releasing transaction will leave the lessor in a worse position than would have

been the case had the defaulting lessee performed.

C. What Efforts Are Required Of The Lessor?

As noted, mitigation is a concept which limits recovery of avoidable losses rather

than requiring any particular effort on the part of the lessor. However, out of self-interest a

lessor will typically take the actions that it feels are best suited to limit its losses because there is

no certainty that the defaulting lessee will be able to pay the damages. Thus, in most instances,

the litigated question will be whether in hindsight the actions actually taken by the lessor to

mitigate its losses are deemed sufficient, such that the actual amount of loss suffered by the

lessor represents only those elements that could not have been reasonably avoided by the lessor.

Though formulated in a variety of ways, a lessor's efforts to mitigate are generally

judged by a standard of reasonableness, taking into account both the costs and risks associated

with the mitigation activity in question and the magnitude of the loss which the lessor is seeking

to avoid.22 Where the lessor has actually undertaken some efforts to mitigate damages, courts

appear to be reluctant to second-guess those efforts and the lessee bears the burden of proving

that the lessor's efforts failed to meet the reasonableness standard.23 Nevertheless, in any given

21 See, Hitz v. First Interstate Bank, 38 Cal.App.4th 274 (C.A. Cal. 1995) (applying the

concept of “lost volume” to a credit card business and noting that since such a business involves the supply of money, it is “expandable”).

22 See, Affiliated Capital Corporation v. Buck, No. 94 C 1497 1994 U.S. Dist. LEXIS 17163, (D.C. N.D. 111. 1994) (a case decided under Article 2A, describing the mitigation duty as "reasonable exertions to render the injury as light as possible" and stating that an injured party may not recover damages which could have been avoided "without undue risk, burden or humiliation"); and Chesrown Leasing Co. v. Auto World, No. 2091 1993 Ohio App. LEXIS 3245 (C.A. Oh. 1993) (in analyzing a lease to which Article 2A was not applicable, the court notes that the doctrine of mitigation requires only "reasonable, practical care and diligence, not extraordinary measures, to avoid excessive damages").

23 Storage Technology Corporation v. The Trust Company of New Jersey, 842 F.2d 54 (3d Cir. 1988) (holding that the burden of proving what losses could have been avoided or reduced is always on the party who broke the contract); Computed Imaging Service, Inc. v. Fayette Memorial Hospital, 03-00-00322-CV 2001 Tex. App. LEXIS 183 (Tex. App. 2001) (holding that the burden of proof as to the degree that damages were mitigated or could have been mitigated lies with the breaching party); AT&T Credit Corporation v. Zurich Data Corporation, 37 F.Supp.2d 367(D.N.J. 1999) (ruling that the breaching party has the burden of proving the facts in mitigation of damages); Simeone v. First Bank National Association, 73 F.3d 184 (8th Cir. 1996)

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circumstance, one can expect a certain degree of uncertainty about whether the lessor's actions

will be accepted in hindsight as satisfying the requirements.

It seems clear enough that the concept of mitigation does not require the lessor to

perform the lessee's obligations for the lessee. For example, if the lessee fails to carry hull

insurance in an amount equal to the stipulated loss value, as required by the lease, the principles

of mitigation would not require the lessor to purchase gap covering insurance even though it may

be entitled to do so under the lease.24

May the concept of mitigation be used to criticize a lessor who fails to act

promptly to repossess an aircraft from a defaulting lessee? Of course, any such scenario raises

questions about whether a lessor has waived its rights. Putting those questions aside, principles

of mitigation can pose a risk for a lessor who neglects to exercise remedies. One recent case

held that even though the lessor had declared a default and the lessee had not offered to return

the equipment to the lessor, the lessor's recovery was limited to past-due rent for the period of

time by which it would have been reasonable for the lessor to retake possession of the equipment

and re-let it.25 This case seems to go much too far in applying the principle of mitigation. The

parties bargained for a lease rate in exchange for possession and use of the equipment and it

seems irrational to excuse the lessee from paying that rate for the full period of time it has

possession of the equipment. This situation would be different if the lessee tendered the aircraft

back to the lessor so that it could be re-let in mitigation of damages.26

Once a lessor has possession of an aircraft, the principle of mitigation requires a

reasonable effort to reduce damages. The requirements of Article 2A differ in this regard from

(finding, in a context of a sale contract, that the breaching party had the burden of proving that the non-breaching party had sufficient funds to mitigate its damages by effecting "cover"). But see, Deutz-Allis Credit Corporation v. Jensen, 458 N.W.2d 163 (C.A. Minn. 1990) (finding an issue of material fact as to the reasonable diligence and good efforts to minimize losses on the re-sale of a leased combine where the actual sale proceeds were less than half the fair market value of the combine).

24 See, Valle de Oro Bank, N.A. v. Gamboa, 26 Cal.App.4th 1686 (C.A. Cal. 1994) (holding that a lessor with the authority under the lease to purchase insurance was not required to do so under the doctrine of mitigation of damages when it found that the lessee had under-insured the lease property in violation of the lease agreement); Rowland v. 1306 Realty Associated, 598 N.Y. S.2d 53 (S.C. NY. 1993).

25 Tokai Financial Services, Inc. v. Mathews, Gallovic, Granito & Co., No. 95-L-098 1995 Ohio App. LEXIS 5163 (C.A. Oh. 1995).

26 See, U.C.C. §2A-529.

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the technical and more restrictive provisions of Article 9. Thus, a lessee would not be able to

claim that a lessor has lost any right to recover any deficiency because it failed to meet the notice

and public sale requirements applicable to a foreclosure sale under Article 9.27 And the fact that

the lessor's efforts were unsuccessful does not mean that the efforts fell below the standard of

reasonableness.28

Nevertheless, the standard of "reasonableness" applicable to a lessor may leave

the lessor uncertain in certain circumstances as to whether the actions it is taking to dispose of a

repossessed aircraft will fully satisfy a court when examined in hindsight. For example, may an

aircraft be re-let in its "as is" condition or is the lessor required to overhaul the aircraft so as to

maximize its re-lease value? Beyond the general principle of "reasonableness", and the notion

that a lessor will not be required to make expenditures and take risks that are disproportionate to

the damages they are seeking to avoid, very little guidance can be offered.

D. Application Of Mitigation Proceeds

Outside of the context of a "lost volume" lessor, when the lessor has retaken

possession of an aircraft and has entered into a re-leasing transaction, it is necessary to determine

whether and how to apply the proceeds from the new lease in relation to the gross amount of

damages attributable to breach of the prior lease. Given all the economic variables in an aircraft

lease, is it appropriate to measure the mitigation limit on recoverable damages by the rent

received in the re-leasing transaction? If market conditions result in a re-leasing transaction that

is substantially more profitable than the defaulted lease, is the lessee entitled to have any portion

of that additional profit applied to reduce its debt for accrued and unpaid rent?

Article 2A recognizes that leasing transactions involve a variety of economic

variables that may substantially alter the calculation of rent. Thus, in the measure of damages

provided by Article 2A, the actual proceeds from a re-leasing transaction are applied only where

the re-letting transaction is "substantially similar" to the defaulted lease.29 It appears that there

are no reported cases as yet on the question of what constitutes a "substantially similar" lease and

the issue does not appear to have been addressed in cases prior to the adoption of Article 2A.

27 See, Addison v. Burnett, 41 Cal.App.4th 1288 (C.A. Cal. 1996).

28 See, Arkoma Associates v. Carden, 874 F.2d 226 (5th Cir. 1988) (rev’d on other grounds) (holding that accelerated rents could be recovered without a reduction for mitigation in a case where the lessor attempted to re-let the drilling rigs but was unsuccessful in doing so).

29 See, U.C.C. §2A-527.

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The comments to Article 2A suggest that all the elements of the new lease need to be evaluated

and considered as a whole in comparison to the defaulted lease and that a commercial judgment

must be made.30 In an aircraft lease, there are so many economic variables that unless the term

"substantially similar" is interpreted to encompass a broad spectrum of transactions, the proceeds

from an actual re-lease transaction may not prove to be the relevant mitigation limit.

In the absence of a "substantially similar" re-letting transaction, Article 2A

measures the mitigation limitation by "market rent."31 The parties are entitled to offer proof of

the going rate in the relevant market, which Article 2A provides is the market where the

equipment is located for leases matching the remaining term of the defaulted lease.

The market for aircraft is cyclical. As a result, it is possible for the market rent at

the time of repossession to exceed the rental rate charged under the defaulted lease.32 In such a

case, the lessee may well argue that it is entitled to not only reduce its obligation to pay future

rents for the unexpired portion of the defaulted lease to zero, but in addition to apply any excess

of market rent over contract rent toward reduction of past-due amounts as well. The argument of

the lessee can be supported by the general proposition that the recovery of damages ought not

place the lessor in a better position than it would have been in had the lessee fully performed. In

the case of a rising market, awarding the lessor the right to recover the full amount of accrued

and unpaid rents and to keep the profit on a releasing transaction made possible by the breach

will result in the lessor being placed in a better economic position than it would have been in had

the lessee performed. Nevertheless, the lessor can be expected to point out that after the lease

has terminated any increase in the lease value of the aircraft belongs to the lessor as the owner of

the aircraft. Permitting the lessee to avail itself of an increase in the market price following a

default would transfer to the lessee a valuable property right of the lessor.

Article 2A makes it clear that a lessee is not entitled to share in the lessor's

residual interest following a default. However, the damage formulae and comments in Article

2A do not clearly address the question of whether releasing profit may be applied to past-due

30 See, Official Comment to U.C.C. §2A-527.

31 See, U.C.C. §2A-507 as to proof of market rent and U.C.C. §2A-528 as to the market rent measure of damages.

32 Such an event occurred in the early 1990s when the market recovered from the 1990-1991 recession. In general, this is very favorable to lessors because defaulting lessees seldom have the financial capability to make their rental payments under the leases, and it is far better for a lessor to obtain a profitable re-lease than to rely on collecting from a defaulting lessee.

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amounts. Both the lessor and the lessee seem to have reasonable positions on this issue, and

general authority on the question of mitigation is mixed.33

IV. Liquidated Damages

A liquidated damage clause affords the parties to a lease the opportunity to define the

elements of loss for which the lessor is entitled to a recovery and to define the extent to which

mitigation concepts may limit that recovery. Liquidated damages clauses are relied upon in

virtually every aircraft lease transaction and the enforceability of such clauses, as written,

arguably becomes more important as the transactions become more complex and the rights and

interests of various participants become more narrowly and precisely defined.34

For example, the United States District Court for the Southern District of New York

recently evaluated a liquidated damage clause in the context of what appears in the facts of the

case to have been a synthetic lease transaction.35 Since such a transaction includes elements of a

recourse loan, a nonrecourse loan and an equity participation, matching the damage award to the

expectations of the parties arguably posed a more sophisticated challenge than might be the case

in an operating lease. In this case, after giving consideration to issues of the relative bargaining

power and sophistication of the lessor and the lessee and making a comparison of the amounts

each participant would have received had the lessee fully performed to the corresponding

amounts which would be paid under the liquidated damages clause, the court upheld the clause

and awarded damages in the amount the clause specified. While the conclusion reached by the

court seems clearly correct on the facts reported, the analysis indicated a bit more uncertainty

about the outcome than the transaction participants might reasonably have anticipated.

In the case mentioned, the lease was not governed by Article 2A. In order to appreciate

the extent to which the adoption of Article 2A has changed the prospects for enforceability of

liquidated damage clauses it is necessary to consider the hurdles posed for such clauses under

33 The lessee's position is supported by Knapp, supra, n.16 at 4-25. The cases considering this issue reach the contrary conclusion. See, Fertico Belgium, S.A. v. Phosphate Chemicals Export Association, Inc., 70 N.Y.2d 76 (1987) (examining the concept in the context of a sale of goods); and Graeff v. Home Federal Savings and Loan Association, 342 S.E.2d 17 (C.A. Ga. 1986) (applying the concept in the context of an automobile lease).

34 The Official Comments to Article U.C.C. §2A-101 state: "Many leasing transactions are predicated on the parties' ability to stipulate an appropriate measure of damages in the event of default."

35 Wilmington Trust Company v. Aerovías de México, S.A. de C. V., 893 F.Supp. 215 (S.D.N.Y. 1995).

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prior law. Under prior law, one could enumerate at least six bases upon which a liquidated

damages clause might be found unenforceable: (1) the liquidated damage amount exceeds the

damages actually suffered; (2) the anticipated damages are not sufficiently difficult to ascertain

to justify use of a liquidated damages clause; (3) the liquidated damage amount is potentially

triggered by breaches that are minor and therefore disproportionate to the liquidated damage

figure; (4) the liquidated damage amount exceeds the reasonably anticipated amount of actual

damages; (5) the liquidated damage amount is available at the election of the lessor as an

optional alternative to seeking actual damages, and therefore is certain to be applied only where

the recovery would exceed actual damages; and (6) the transaction involves elements of

unconscionability.36

In contrast to these restrictive common law principles, Article 2A specifically endorses

the use of liquidated damages clauses as follows:

Damages payable by either party for default, or any other act or omission, including indemnity for loss or diminution of anticipated tax benefits or 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 or other act or omission. UCC §2A-504(1).

Thus, Article 2A makes it clear that the parties have broad latitude in defining the

elements of loss that may be recoverable following a breach. Further, the standard against which

a liquidated damage clause is tested under Article 2A is its "reasonableness" in light of the

anticipated harm at the time the lease is entered into. As result, the liquidated damage amount

could, when applied, result in a larger recovery for the lessor than the lessor's actual damages.37

36 Candace S. Kovacic-Fleischer, 1 Commercial Damages, Ch.9A "Agreed Remedies:

Contractual Clauses Dealing with Monetary Relief", (Knapp ed. 1996) at 9A-38.

37 See, Marion W. Benfieid, "Lessor's Damages Under Article 2A After Default By The Lessee Is To Accepted Goods", 39 Ala. L.Rev. 915 (1988). In some jurisdictions, case law prior to the adoption of Article 2A resulted in the same potential recovery. See, PacifiCorp Capital Inc. v. Tano, Inc., 877 F.Supp. 180 (S.D.N.Y. 1995) (upholding a liquidated damages clause based upon the stipulated loss value of the leased equipment even though actual damages were arguably one-third less than the stipulated damage amount). Nevertheless, under Article 2A, the liquidated damages recovery must ultimately pass the "reasonableness" test. See Carter v. Tokai Financial Services, Inc., 500 S.E.2d 638 (Georgia Ct.App. 1998) (holding that a liquidation damage calculation allowing for the recovery of the present value of all future rent, together with the amount of the fair market value of the equipment was unreasonable); and Coastal Leasing Corp. v. T-Bar S Corp., 496 S.E.2d 795 (N.C. Ct.App. 1998) (finding that a liquidated damages clause allowing for the recovery of an amount equal to all future rental payments less the amount received from the re-lease or sale of an equipment was reasonable). Under California law, the party seeking to invalidate a liquidated damages clause has the burden of demonstrating that the

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While it is clear that Article 2A rejects any notion that anticipated damages must be

difficult to ascertain and that the liquidated damage amount may not exceed actual damages,

elements of the four other bases for invalidating a liquidated damages clause remain. Article 2A

applies an unconscionability test to all portions of a lease agreement, including the liquidated

damages clause.38 In addition, Article 2A's test of reasonableness in light of the anticipated loss

would seem sufficiently broad to invalidate a liquidated damage clause that is triggered by an

inconsequential breach.

It is less clear how a court would treat a liquidated damage clause that the lessor had the

option to select liquidated damages as an alternative to seeking a recovery of actual damages.

However, providing the alternative to a lessor of recovering its actual damages, by definition, is

not at all offensive to the general principle that the lessor should be able to achieve a recovery

that places it in the same position as it would have been in had the lessee fully performed. While

this issue has not yet been addressed, it seems that a liquidated damages clause which otherwise

represents an attempt to permit the lessor to recover its reasonably anticipated loss should not be

found unenforceable on the basis that the lessor was afforded, as a safety net, the alternative of

proving its actual damages.

How should a liquidated damages clause be evaluated in light of the "reasonableness"

standard established by section 2A-504? Certainly relevant are the principles discussed in

Sections II and III of this paper concerning the elements appropriately included in calculating the

lessor's damages and the extent to which recovery of damages is limited to the elements of loss

which cannot be avoided through reasonable endeavors. Obviously, any liquidated damage

clause that includes unrealistic estimates of loss or unrealistic estimates of the effect of

reasonable attempts to mitigate damages will be subject to attack.39 Further, a liquidated damage

cause was "unreasonable under the circumstances existing at the time the contract was made.” Cal. CC §167(b).

38 See, U.C.C. §2A-108.

39 See Interface Group—Nevada, Inc. v. Trans World Airlines Inc. (In re Trans World Airlines, Inc.), 145 F3d 124 (3d Cir. 1998) (finding that a liquidated damages clause which required the lessee to be liable for the difference between a stipulated termination value stated in the lease and either the fair market rental value or the fair market sale value of the aircraft on the default date (the lessor had the sole discretion to choose which terms to enforce) was unenforceable; and ATEL Financial Corporation v. Quaker Coal Company, 132 F.Supp.2d 1233 (ND Cal. 2001) (liquidated damages clause will be considered unreasonable, and therefore unenforceable, if it does not bear a reasonable relationship to the range of actual damages that the parties could have anticipated would flow from the breach).

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clause that includes in the recovery amounts that are not related to the anticipated harm caused

by the default will also be vulnerable. Thus, while Article 2A grants the parties latitude in

agreeing upon their measure of damages, there are limits.

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