Bankruptcy

Acceleration Clauses in the Event of Default – Are they enforceable?

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All leases have an acceleration clause when there is a default, however there is not a consistent approach as to what the damages will be. Some leases require the defaulted lessee to pay the balance of payments due without discount while others utilize a net present value formula applying a discount rate close to, but generally below, the interest rate implied in the lease. A few still use “the rule of 78’s”  (but few under 50 know what that means). The recent case, Hav-A-Kar Leasing Ltd. v. Vekselshtein 2012 ONCA 826 (“Hav-A-Kar”) discussed this matter but may have not quite got it right.

            In Hav-A-Kar the Court accepted acceleration clauses as being enforceable (there was an argument before the Court that they were not). In this case the acceleration clause did not discount payments but required the balance of payment be made. This type of clause is problematic as it gives the lessor a greater return than it would have received had the agreement been fulfilled. This is contrary to the long standing legal principle of awarding damages for a breach of contract, to put the injured party in the same position as if the contract had been properly performed. If the lessor were to collect full payments at the time of default the lessor would be in a better position than had the default not occurred. A net present value calculation, on the other hand, takes the time value of money into account and if properly formulated should place the lessor in the same position it would have been in had the contract been completed.

            Another long standing principal under Canadian law is that penalty clauses in an agreement may not be enforceable. If the payment amount received by the lessor is viewed as a penalty clause then there is a significant chance that the entire acceleration clause will be thrown out. In most well drafted leases the phrase “a genuine pre-estimate of damages and not as penalty” is used to obtain this result. If the balance of payment formulation is used without this description, then there is a risk that it would be viewed as a penalty due to the lessor being in a better position, as noted above.

            In Hav-A-Kar the lease agreement was not surprisingly for a motor vehicle and provided for the balance of payment upon default. When the lessee defaulted and the lessor sued for damages, including enforcement of the accelerated payment clause. The trial judge rejected the lessee’s argument that the payment clause was a penalty, as opposed to a liquidated damages clause. The lessee appealed and was dismissed. The Court of Appeal in making its determination relied on the well established principle that damages for breach of contract should put the plaintiff in the same position as if the contract had been performed. It was found that the accelerated payment clause was not excessive, it simply put the lessor in the position it would have been if the lessee performed its obligations under the lease agreement.

            The Court relied on the Supreme Court’s decision Keneric Tractor Sales Ltd. v. Langille, [1987] 2 S.C.R. 440 (“Keneric Tractor”), as precedent for the enforcement of payment acceleration clauses, however this case acknowledges the need to discount future payments to properly reflect the time value of money. The Court ignored the net present value concept in its reliance on Keneric Tractor. Hav-A-Kar also relied on the reasoning in  Peachtree II Associates – Dallas LP v. 857486 Ontario Ltd. (2005) 76 O.R. (3d) 362 (C.A.) (“Peachtree”) which allows for the enforcement of penalty clauses based on the courts reluctance to interfere with the parties right to freedom of contract.

            The likely reasoning, which was not set out in the case, was that the Court recognized the clause in the lease agreement could be considered a penalty clause, but then relied upon Peachtree for the ability to enforce a clause regardless of its a potential penal effect. Another potential factor that the Court may have taken into account but did not specifically address in the decision, is the possibility that the differential between the full value of the remaining payments and the discounted value of those payments was so minute that applying discount would have little relevance; this is particularly likely given that it is a small ticket lease and a low interest rate environment.

            It would have been helpful in Hav-A-Kar to know how the court came to its decision. The concern is that a lessor may rely on this decision when drafting its lease and then a subsequent decision is rendered where Hav-A-Kar is accepted in principle, that is acceleration clauses are acceptable, but distinguishes Hav-A-Kar on the formula utilized. A lessor may have its lease acceleration clause struck down when it thought it was following the law. Accordingly, we are advising our client to stay with a net present value calculation.

Jonathan Fleisher is a partner in the Financial Services and Business Law groups of Cassels Brock.  He can be reached at jfleisher@casselsbrock.com

Source: Jonathan Fleisher, Cassels Brock

Published under: Bankruptcy
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