                                                                                                                           Opinions of the United
2003 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


4-14-2003

In Re: Montgomery
Precedential or Non-Precedential: Precedential

Docket 01-4286




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"In Re: Montgomery " (2003). 2003 Decisions. Paper 590.
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                                   PRECEDENTIAL

                                               Filed April 14, 2003

            UNITED STATES COURT OF APPEALS
                 FOR THE THIRD CIRCUIT


                            No. 01-4286


                       IN RE:
          MONTGOMERY WARD HOLDING CORP.,
           A DELAWARE CORPORATION, ET AL.,
                REORGANIZED DEBTORS
                 MONTGOMERY WARD & CO.,
                  INCORPORATED, ET AL.,
                        Appellees
                                  v.
             MERIDIAN LEASING CORPORATION,
                        Appellant

       Appeal from the United States District Court
                 for the District of Delaware
                    (D.C. No. 01-cv-00056)
      District Judge: Honorable Joseph J. Farnan, Jr.

                   Argued February 24, 2003
  Before: BECKER, Chief Judge, SCIRICA, Circuit Judge,
             and SHADUR,* District Judge

                 (Opinion filed: April 14, 2003)




* Honorable Milton I. Shadur, United States District Court Judge for the
Northern District of Illinois, sitting by designation.
                             2


                      Daniel J. DeFranceschi
                      Michael J. Merchant
                      RICHARDS, LAYTON & FINGER
                      One Rodney Square
                      Wilmington, Delaware 19899
                      Kelley M. Griesmer (Argued)
                      JONES, DAY, REAVIS & POGUE
                      41 South High Street, Suite 1900
                      Columbus, Ohio 43215
                        Attorneys for Appellees
                      Howard L. Teplinsky (Argued)
                      Seidler & McErlean
                      One North Wacker Drive
                      UBS Tower, Suite 4125
                      Chicago, Illinois 60606
                      John D. Demmy
                      Stevens & Lee, P.C.
                      300 Delaware Avenue, 8th Floor,
                       Suite 800
                      Wilmington, Delaware 19801
                        Attorneys for Appellant

                OPINION OF THE COURT

SHADUR, District Judge:
   Meridian Leasing Corporation (“Meridian”) appeals from
an order of the United States District Court for the District
of Delaware that reversed an order of its Bankruptcy Court
by reducing the amount of the rejection damages claim that
Meridian had filed against Montgomery Ward Holding Corp
and Montgomery Ward & Co., Inc. (collectively “Montgomery
Ward”). We affirm the District Court’s decision that
Meridian has sought to recover an amount that represents
uncollectible punitive damages, but we remand for a
determination of Meridian’s damages at common law.

                        Background
  At issue on the current appeal are equipment leases
running from Meridian to Lechmere, Inc. (“Lechmere”), a
                                 3


wholly owned subsidiary of Montgomery Ward: an October
5, 1995 Master Lease Agreement (“Master Lease”) that
contemplated the leasing of computer equipment and two
later Supplements that described and specified certain
leased equipment, lease terms, rental payments, equipment
locations, commencement dates and expiration dates.
Montgomery Ward guaranteed Lechmere’s obligations under
the Master Lease and its Supplements.
  On July 7, 1997 Montgomery Ward and other affiliated
entities (including Lechmere) filed voluntary petitions for
relief under Chapter 11 of the Bankruptcy Code.1 On
November 17, 1997 Montgomery Ward and Meridian
entered into an agreement for the rejection of the
Supplements pursuant to Section 365, creating agreed-
upon defaults on the lessee’s part. About two weeks later
the Bankruptcy Court granted Montgomery Ward’s motion
to reject the Supplements (each of which then had some ten
months remaining before it would expire by its terms).
Meridian then filed claims against Montgomery Ward that
asserted damages stemming from the rejection of the
Supplements.
  Master Lease § 10 (A-77-78) defines Lechmere’s
bankruptcy as an Event of Default and sets out the remedy
that Meridian then elected to pursue:
     (a) Each of the following shall constitute an Event of
     Default hereunder: . . . (iii) Lessee [Lechmere] becomes
     insolvent or admits in writing its inability to pay its
     debts as they mature, or applies for, consents to, or
     acquiesces in the appointment of a trustee or a receiver
     or similar officer for it or any of its property, or . . . a
     trustee or receiver or similar officer is appointed for
     Lessee . . . and is not discharged within 15 days, or
     any bankruptcy, reorganization, debt, dissolution or
     other proceeding under any bankruptcy or insolvency
     law . . . is instituted by or against Lessee. . . .
     (b) Upon the occurrence of an Event of Default . . .
     Lessor [Meridian] may, at its option, declare this Lease

1. Citations to the Code will take the form “Section —,” using the 11
U.S.C. section numbering rather than the Code’s internal numbering.
                             4


    to be in default by notice to Lessee, and thereafter
    exercise one or more of the following remedies, as
    Lessor in its sole discretion lawfully elects:
                         *   *    *
      (2) By notice terminate this Lease, whereupon all
      rights of Lessee in the Equipment will absolutely
      cease but Lessee will remain liable as hereinafter
      provided; and thereupon Lessee, if so requested, will
      at its expense promptly return the Equipment to
      Lessor at the place designated by Lessor. . . . Lessee
      will, without further demand, forthwith pay Lessor
      an amount equal to any unpaid Rent due and
      payable for all periods up to and including the
      Monthly Rent payment date following the date on
      which Lessor has declared this Lease to be in
      default, plus, as liquidated damages for loss of a
      bargain and not as a penalty, an amount equal to
      the Casualty Value of the Equipment then subject to
      this Lease, computed as of such Monthly Rent
      payment date.
In turn, “Casualty Value” was defined in Supplements 1
and 2.
  Supplement 1 (A. 83-120) was an October 13, 1995 sale-
leaseback transaction in which Meridian, having financed
the cost of the equipment involved, leased it back to
Lechmere for 36 months at a monthly rental of $144,720.
(Red 9). Although Meridian had purchased the equipment
for $6,070,923, the present value of Lechmere’s total rental
obligation at the commencement of the lease term was only
$4,697,875.64. (A. 36). Supplement 1’s Schedule B
specified the “Casualty Value” of the leased equipment (the
amount that Lechmere would have to pay in the event of a
default during the lease term): (A. 118)
         Months Expired After
    Supplement Commencement Date            Casualty Value
                    0                        $6,981,562
                    12                        5,378,315
                                   5


                         24                              4,010,672
                         362                             3,067,460
  Supplement 2 was an April 29, 1996 transaction (with a
May 1 commencement date) (A. 121-28) under which
Meridian agreed to purchase equipment from an
independent vendor and then lease it to Lechmere for 29
months at a monthly rental of $3,972 . (A. 37). Although
Meridian paid $130,620 for the equipment, the present
value of the rental stream was only $104,824.68. (A. 37).
Supplement 2’s Schedule B prescribed the “Casualty Value”
of the leased equipment: (A. 127)
          Months Expired After
     Supplement Commencement Date                     Casualty Value
                         0                              $150,428
                         12                              107,912
                         24                               74,974
                         293                              64,647
   Meridian’s Senior Vice President and Chief Financial
Officer Michael Brannan (“Brannan”) explained how the
Casualty Value figures had been derived. According to his
affidavit, (A. 38) each number was the sum of three
components:
       1. “the present value of the unpaid rent through the
     term of the lease,”
       2. “the present value of the residual value of the
     equipment necessary for Meridian to recover its
     investment” and
       3. “an amount allowing Meridian to realize a profit
     on the transaction.”
  Two other provisions of the Master Lease (and hence of
each Supplement) bear mention. Master Lease § 12(d)
stated that Lechmere was not obligated to renew its lease or
to purchase any of the equipment. (A. 80). And Master

2. This 36-month figure was stated as the “Casualty Value” after the end
of the lease term until the equipment itself was surrendered to Meridian.
3. See n.2.
                              6


Lease § 13(g) designated Illinois law as providing the
substantive rules of decision. (A. 81).

                    Standard of Review
   Because the bankruptcy court rather than the district
court was the trier of fact in this case, “[w]e are in as good
a position as the district court to review the findings of the
bankruptcy court, so we review the bankruptcy court’s
findings by the standards the district court should employ,
to determine whether the district court erred in its review”
(In re Fegeley, 118 F.3d 979, 982 (3d Cir. 1997), quoting
Universal Minerals, Inc. v. C.A. Hughes & Co., 669 F.2d 98,
102 (3d Cir. 1981)). While we review basic and inferred
facts under the clearly erroneous standard, we exercise
plenary review over legal issues (id.). Hence when we review
ultimate facts—“a mixture of fact and legal precept”—we
must differentiate between those two categories and “apply
the appropriate standard to each component” (id.).

      Liquidated Damages v. Unenforceable Penalties
  Although the Master Lease characterizes the Casualty
Value figures “as liquidated damages for loss of a bargain
and not as a penalty,” Illinois caselaw teaches that the
tyranny of labels does not extend to the terms that are
attached by parties to a contract. Instead the
“determination of whether a contractual provision for
damages is a valid liquidated damages provision or a
penalty clause is a question of law” for the court
(Grossinger Motorcorp, Inc. v. Am. Nat’l Bank & Trust Co.,
607 N.E. 2d 1337, 1345 (Ill. App. 1992). To that end both
parties (Blue 18, Red 14) point to the Illinois version of the
Uniform Commercial Code (“U.C.C.”) § 2A-504 (enacted as
810 ILCS 5/2A-504):
    Liquidation of damages. (1) 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
                                  7


     is reasonable in light of the then anticipated harm
     caused by the default or other act or omission.
And the Official Comment to that provision places flesh on
its bones by setting out a standard that Meridian itself
(Blue 18) confirms is an appropriate yardstick—particularly
useful in this case—for testing the validity of a liquidated
damages provision:
     A liquidated damages formula that is common in
     leasing practice provides that the sum of lease
     payments past due, accelerated future lease payments,
     and the lessor’s estimated residual interest, less the
     net proceeds of disposition (whether by sale or re-lease)
     of the leased goods is the lessor’s damages.
  Analysis of the issues here is materially advanced by a
preliminary exposition of some fundamentals of leasing.
From the lessor’s perspective, its lease rights in the absence
of a lessee’s contractual obligation to purchase the leased
property at the end of the term4 comprise (1) its entitlement
to the rental flow and (2) its right to the return of the leased
property at the end of the term (in the latter respect, see
U.C.C. § 2A-103(q)). Thus any lessor that seeks an assured
yield for its investment in the purchase of property to be
leased out will peg the lease rentals at a level that, taking
into account the expected value of the property to be
returned at the end of the term, will generate that desired
yield. To put the transaction in economic terms, the present
value of the designated rental flow at the commencement of
the lease term plus the present value of the expected
remainder interest combine to provide an amount that
represents the original investment in the property plus the
desired profit from the lease transaction.
  But a lessor is not of course compelled to structure the
lease in such a self-amortizing fashion. In order perhaps to
make its rental rate more attractive (because lower) than
what may be offered by competitive leasing companies, the

4. Such an obligation would convert what is normally a lease into what
is really a loan transaction, with the lessor providing property of a
certain value in exchange for the repayment of that value plus a fixed
yield.
                              8


lessor may choose to take the chance that the lease may be
renewed at the end of the term at a rate such that any
shortfall in the present value of the total rental flow
produced by the original lower rental rate will be made up
for by the greater value hoped to be realized after the initial
lease term has run its course. But by definition that is a
risk-taking decision, and one that is made even more risky
by the possibility of a lessee’s default before the full term
has ended.
  That latter event is precisely what has taken place here,
and the question as to whether Meridian’s option to
structure its transaction in that manner involves the
sought imposition of a penalty (rather than liquidated
damages) must be examined in those terms. We turn then
to that task.
   Although Illinois courts have not yet taken the occasion
to look to the earlier-quoted U.C.C. § 2A-504 to decide on
the validity of a claimed liquidated damages provision in
the lease context, their consistent approach to all damages
issues is that the victim of a breach cannot be placed in a
better position than it would have occupied if the contract
had     been    performed      (see,   e.g.,  that   accurate
characterization of Illinois law in Target Market Publ’g, Inc.
v. ADVO, Inc., 136 F.3d 1139, 1145 (7th Cir. 1998)). And in
the present context that conforms to the view adopted by
the majority of courts that have construed the U.C.C.
provision: No true liquidated damages provision can put the
lessor in a position legally superior to the one that it would
have occupied had the lease been fully performed (see, e.g.,
Carter v. Tokai Fin. Servs. Inc., 500 S.E. 2d 638, 641 (Ga.
App. 1998); Coastal Leasing Corp. v. T-Bar S Corp., 496
S.E.2d 795, 797-99 (N.C. App. 1998); In re Baldwin Rental
Ctrs., Inc., 228 B.R. 504, 507-10 (Bankr. S.D. Ga. 1998)).
  In those terms the requisite comparison must be to
Meridian’s entitlement if each lease had indeed been fully
performed—a quantification most readily made in the
analytical terms that we have set out earlier (for
convenience we will look only at Supplement 1, for the
analysis as to the far smaller Supplement 2 amount would
be no different). We have been given the present value of
the 36-month rental stream at Supplement 1’s lease
                                    9


commencement date as $4,697,875.64. (Blue 9). Although
we are not furnished a precise number for the present
value of the remainder interest at the outset (that is, the
then-expected value of the equipment as it would be at the
end of the lease, discounted to present value), we know that
it must have been less than $1,373,047.93. (id.). And that
is so because Meridian’s actual cost of the equipment
(without any profit component at all) was the sum of those
two figures ($6,070,923.57). (id.). Indeed, from the fact that
the ultimate sale of the recaptured equipment post-default
(ten months before the leases’ expiration date) came to just
$486,960—less than 8% of the equipment’s original cost—it
would seem likely that the original present value of the
remainder interest would have been more in that order of
magnitude. And because, from Meridian’s vigorous
argument that it obviously had to collect much more than
its original cost to realize its hoped-for profit, we know that
the specified level of rent did not suffice to cover all except
that remainder interest.
  As against those numbers, the recovery of the specified
Casualty Values would place Meridian in a far, far better
position than its actual damages, which constitute the
current equivalent of what the lease would have generated
in the ordinary course—that is, the sum of the present
value of future rentals to the end of the lease plus the
present value of the remainder interest in the property at
the end of the lease. There can be no question about any of
that, for Meridian’s own Senior Vice President and Chief
Financial Officer Brannan confirmed that the Casualty
Values included not only those two present values but also
“an amount allowing Meridian to realize a profit on the
transaction.”5

5. Even Brannan’s statement of the second present value component
seems suspect. As quoted earlier, he referred to “the present value of the
residual value of the equipment necessary for Meridian to recover its
investment” (emphasis added). If that statement was intended to mean
something more than the present value of the remainder simpliciter, it
too would pose a problem as a reflection of Meridian’s real damages. But
that question need not be explored further, for the language just quoted
in the text confirms that the amount sought by Meridian does not
represent real damages, but rather an unrecoverable penalty.
                                   10


   Even though the reasonableness of any liquidated
damages provision must be tested ex ante rather than ex
post, an examination of the situation when the Master
Lease and Supplements were actually rejected provides a
graphic demonstration of the penalty represented by the
Casualty Value provisions. At that time, apart from any
past-due rents and the duty to return the leased
equipment, Lechmere’s sole financial obligation in terms of
current dollars came to something less than $1,486,920.6
But Meridian’s demand for payment of the Casualty Values
sought over $2 million in excess of that: $3,500,115 over
and above the $486,966 realized on resale of the
equipment. As Meridian characterizes that demand, the
entire present value of the rental streams will go directly to
Meridian’s lender to cover outstanding debts from the
purchase of the equipment, (Blue 23) while $1,398,843.14
is sought to cover Meridian’s initial investment and the rest
represents Meridian’s attempt to “earn a gross ‘profit’ of
$655,712 on the transaction, in line with its historical
returns.” (Blue 23).
   That alone confirms that Meridian’s effort is to realize
what it hoped to gain—but had no assurance of obtaining—
from the transaction, rather than its demonstrable damages
measured by what Lechmere would have had the absolute
right to do at the end of the lease term: to return rather
than to buy, or continue to lease, the equipment. And that
is the sure proof that the Casualty Value did not represent
(in fact, did not even begin to approach) a far lesser
liquidated damages figure.
  As further confirmation of that conclusion, two other
ways in which Illinois law has characterized the distinction
between penalties and liquidated damages command the
identical conclusion. We address them briefly.
  First, Stride v. 120 W. Madison Bldg. Corp., 477 N.E.2d
1318, 1321 (Ill. App. 1985), after reconfirming that the
general damages principles of contract law extend to cases

6. That figure, awarded by the district court, is the total rent under the
two Supplements for the remaining ten months of the lease term,
without reduction to present value.
                             11


involving the breach of a lease, is exemplary of a number of
Illinois cases that consistently teach:
    Where damages are difficult to ascertain, the parties
    may specify a particular sum as liquidated damages.
    However, if the clause fixing damages is merely to
    secure performance of the agreement, it will be treated
    as a penalty and only actual damages proved can be
    recovered. In doubtful cases, we are inclined to
    construe the stipulated sum as a penalty.
In those terms there is no question that the Casualty
Values had as their purpose “to secure performance of the
agreement.” In comparison to the actual financial
obligations called for by performance of the leases
(remembering that Lechmere had no contractual obligation
at the end of the term other than to return the equipment),
the excessively large Casualty Value figures provided
powerful in terrorem pressure for Lechmere to perform the
leases rather than (for example) to terminate them
voluntarily and pay the price for doing so in real damages.
And the situation is of course no different when we look at
a premature termination triggered by bankruptcy.
   Still another perspective, and one that compels the
identical result, is furnished by an examination of how the
Casualty Values would themselves operate. To choose only
an example or two, if Lechmere had breached Supplement
1 in the first month of the lease term, Meridian would have
been entitled to so-called “liquidated damages” of
$6,981,562—but if Lechmere had instead breached on the
last day of the twelfth month (with Meridian having already
received 12 monthly payments of $144,720, or $1,736,640),
it would still receive the identical Casualty Value payment
of $6,981,562. And if Lechmere had breached just one day
later (on the first day of the thirteenth month), Lechmere’s
Casualty Value payment would have dropped to $5,378,315
—a difference of $1,603,247 for a mere 24 hours.
   It is scarcely necessary to multiply the examples. What
cannot be gainsaid is that such purported damages are
“invariant to the gravity of the breach” (Raffel v. Medallion
Kitchens of Minn., Inc., 139 F.3d 1142, 1146 (7th Cir.
1998), decided under Illinois law)—again a hallmark of an
                             12


unenforceable penalty rather than a bona fide effort to
quantify actual damages, as is permissible for a liquidated
damages provision.
  To recapitulate, Meridian deliberately chose to establish
a lease pricing structure that substituted a lower (and thus
more attractive to a lessee) monthly rental, with the
potential for recoupment of its investment plus a profit
through a hoped-for (but in no way assured) course of
events after the lease ran its course, for a safer (but less
attractive) higher rental that (when coupled with the
expected value of the remainder interest) would provide for
amortization of the investment and profit during the lease
term. It cannot be heard to say that it made that choice in
ignorance of the well-established Illinois doctrine that
blocks purported liquidated damages provisions that the
courts instead classify as penalties.
  As Checkers Eight Ltd. P’ship v. Hawkins, 241 F.3d 558,
563 (7th Cir. 2001)(citations omitted) has explained,
reflecting a difference of view as to the desirability of that
doctrine but recognizing the proper role of the federal
courts in mirroring state law in diversity cases:
    While we have noted similar criticisms in this circuit’s
    opinions      discussing     Illinois   penalty    clause
    jurisprudence, Illinois continues to invalidate damages
    provisions in contracts that fail the test outlined above
    even if both parties are economically sophisticated. The
    plaintiffs’ argument would prove too much if accepted,
    because then no damages clause between commercially
    experienced parties could be considered a penalty,
    which clearly contradicts actual Illinois law. Since, as
    aforementioned, we apply Illinois law in this case, we
    must reject the plaintiffs’ argument.
In short, Meridian gambled on the future and lost—and
because its hoped-for recoupment constituted an
unenforceable penalty, it cannot shift the risk of that loss
to Montgomery Ward.
  Every analytical road thus leads to the same destination:
What are stated in the Supplements as Casualty Values
serve as an attempted penalty, not as legitimate liquidated
damages. Meridian cannot thereby convert its hopes (or
                             13


even expectations) of a favorable lease renewal at the end of
the lease term into a right that it did not possess as an
entitlement by reason of its status as a lessor, to whom its
lessee had the unfettered right simply to return the
equipment at lease end.
   All of that having been said, however, we cannot simply
affirm the decision below, even though the district judge
certainly reached the correct conclusion as to the
unenforceability of the Casualty Values provisions.
Although the parties have limited their argument to that
question, the consequence of invalidity of an attempted
penalty is not to penalize the lessor for such overreaching.
Instead the principle is that stated in Lake River Corp. v.
Carborundum Co., 769 F.2d 1284, 1292 (7th Cir. 1985)
after the court there had rejected a purported liquidated
damages provision on penalty grounds under Illinois law:
    The fact that the damage formula is invalid does not
    deprive Lake River of a remedy. The parties did not
    contract explicitly with reference to the measure of
    damages if the agreed-on damage formula was
    invalidated, but all this means is that the victim of the
    breach is entitled to his common law damages. See,
    e.g., Restatement, Second, Contracts § 356, comment a
    (1981).
Accord, again applying Illinois law, Checkers Eight, 241
F.3d at 563.
  To repeat the operative standard, at the time of breach
Meridian was entitled to receive the sum of (1) the amount
of any unpaid rent, (2) the present value at the time of
breach of the monthly rentals for the then-remaining 10
months of the leases and (3) the then-present value of what
would have been, when the lease terms began, the
anticipated aggregate residual value of the leased
equipment at the scheduled termination of the leases. It
does not appear from the record that the first component
was involved at all. As for the second, the sum of
$1,486,920 awarded by the distsrict court represented the
accelerated future rents without reduction (however
modest) to their then present value. And the third
component was never evaluated at all. Instead the district
                             14


court allowed to Meridian the full amount of the future
rentals plus the $486,960 in net proceeds realized from the
resale of the returned equipment.
  We cannot be certain whether the district court’s
formulation    overcompensated      or   undercompensated
Meridian in terms of the proper measure of damages that
we have outlined. If the former is the case, the present
award will stand because Montgomery Ward has not taken
a cross-appeal. But the second possibility—that the
combined value of the $1,486,920 award plus the $486,960
in sale proceeds is less than the second and third elements
identified in the preceding paragraph—poses a question
that must be answered by the district court on remand.

                        Conclusion
  We AFFIRM the district court’s determination that the
Casualty Values specified in the Supplements constituted
an unenforceable penalty, but we REMAND for a
determination as to Meridian’s actual damages in
accordance with this opinion. We award costs to
Montgomery Ward.

A True Copy:
        Teste:

                  Clerk of the United States Court of Appeals
                              for the Third Circuit
