JMD HOLDING v. CONGRESS FIN.

• Decision Date: 31 March 2005
• Citation: 828 N.E.2d 604,4 N.Y.3d 373,795 N.Y.S.2d 502
• Parties: JMD HOLDING CORP., Respondent, v. CONGRESS FINANCIAL CORPORATION, Appellant, et al., Defendant.
• Court: New York Court of Appeals Court of Appeals

4 N.Y.3d 373

828 N.E.2d 604

795 N.Y.S.2d 502

JMD HOLDING CORP., Respondent, v. CONGRESS FINANCIAL CORPORATION, Appellant, et al., Defendant.

Court of Appeals of the State of New York.

Argued February 15, 2005.

Decided March 31, 2005.

Otterbourg, Steindler, Houston & Rosen, P.C., New York City (Richard G. Haddad, Daniel Wallen and Stuart J. Wells of counsel), for appellant.

Loeb & Loeb LLP, New York City (David B. Eizenman, Paula K. Colbath and Ronald L. Israel of counsel), for respondent.

Balber Pickard Battistoni Maldonado & Van Der Tuin, PC, New York City (Thomas P. Battistoni of counsel), and Goldberg Kohn Bell Black Rosenbloom & Moritz, Ltd., Chicago, Illinois (Richard M. Kohn and Kenneth Ulrich of counsel), for Commercial Finance Association, amicus curiae.

Chief Judge KAYE and Judges G.B. SMITH, CIPARICK, ROSENBLATT, GRAFFEO and R.S. SMITH concur.

OPINION OF THE COURT

READ, J.

In this action, JMD Holding Corp. seeks to recover $600,000 charged to its loan account by Congress Financial Corporation for early termination of the parties' $40 million commercial revolving loan agreement. After JMD paid off its outstanding loans, Congress also retained leftover funds in JMD's account as a cash collateral reserve to cover losses, including attorneys' fees, allegedly related to JMD's contingent obligations under the loan agreement. JMD also seeks to recover these funds. For the reasons discussed below, we conclude that JMD has not satisfied its prima facie burden to show that the $600,000 early termination fee is an unenforceable penalty. We also conclude that Congress was not entitled to keep the cash collateral reserve.

I.

On August 22, 1997, JMD's predecessor entered into a Loan and Security Agreement with Congress. Under the agreement, Congress agreed to make loans "from time to time in amounts requested by [JMD's predecessor]" in accordance with an asset-based lending formula and up to a maximum credit of $5 million. On January 20, 1998, JMD and Congress executed an Amended, Restated and Consolidated Loan and Security Agreement (Agreement) to increase JMD's maximum credit to $40 million. JMD committed to borrow from Congress to finance its working capital needs through the end of the Agreement's term on August 21, 2000, subject to renewal from year to year thereafter on at least 60 days' written notice.

To secure payment and performance of its obligations¹ under the Agreement, JMD granted Congress "a continuing security interest in, a lien upon, and a right of set off against" its assets, most pertinently including accounts receivable and inventory and their proceeds. The Agreement required JMD and its "account debtors" to direct all payments on accounts or payments constituting proceeds of other collateral into blocked bank accounts or "lockboxes." JMD agreed that all payments made into the lockbox were Congress's property. These funds were transferred or "swept" on a daily basis from the lockbox into Congress's bank account, and were applied by Congress to pay down the outstanding obligations in JMD's loan account, thus creating availability for new revolving advances.

Interest on the outstanding principal amount of noncontingent obligations was set at 1.5% above the prime rate per annum. At Congress's option and without notice, interest was set at 3.5% above the prime rate per annum on noncontingent obligations for the period from and after the Agreement's termination or nonrenewal or JMD's default until payment; and on any outstanding loans in excess of amounts JMD was eligible to borrow (e.g., advances in excess of amounts available to JMD under the Agreement's asset-based lending formula).

The Agreement afforded Congress seven nonexclusive remedies for JMD's breach, including the right to terminate.² Further, if the Agreement was terminated prior to the end of any term, JMD was required to pay Congress an early termination fee of between 1% and 2% of the $40 million maximum credit. The percentage decreased as the end of the Agreement's term drew closer; that is, the closer the termination to the end of a term, the lower the fee.

The Agreement recited that the early termination fee was required "in view of the impracticality and extreme difficulty of ascertaining actual damages and by mutual agreement of the parties as to a reasonable calculation of [Congress's] lost profits as a result [of early termination]." Further, the fee was "presumed to be the amount of damages sustained by [Congress] as a result of such early termination," and JMD "agree[d] that it [the early termination fee] [was] reasonable under the circumstances currently existing."

On June 22, 1999, Congress sent JMD notice of default in light of JMD's failure to comply with multiple provisions of the Agreement, including those governing collateral reporting and covenants as to accounts receivable and inventory; requirements to maintain minimum working capital and adjusted net worth; and delivery of required documentation, including audited financial statements and reports. JMD does not contest that it was in default. Congress accelerated the payment of all JMD's obligations and demanded their immediate repayment, one of its remedies under the Agreement.

As of the date of the notice of default, the early termination fee was $600,000 (1.5% of $40 million). On July 1, 1999, the parties executed a letter agreement, by which Congress agreed to forgive or discount the early termination fee if JMD paid off its indebtedness before September 3, 1999.³ As it turned out, JMD did not pay all its outstanding obligations to Congress before the end of this grace period.

On November 10, 1999, Congress charged JMD's loan account in the amount of $600,000 for the early termination fee. JMD paid Congress all loan balances, both principal and interest, no later than November 23, 1999. Nonetheless, Congress continued to retain the remaining funds in JMD's loan account as a cash collateral reserve to cover losses, including attorneys' fees, purportedly related to JMD's contingent obligations.

On December 28, 2000, JMD commenced this action, which included causes of action asserting that Congress had converted approximately $800,000 of JMD's property and for money had and received in the same amount.⁴ JMD moved for summary judgment on these claims, arguing that the early termination fee was an unenforceable penalty, not legitimate liquidated damages, and that Congress had no right to retain cash collateral. In support of its motion, JMD offered the affidavit of its president, who attested in conclusory fashion that, based on the memorandum of law prepared by JMD's attorney, the early termination fee was an "unenforceable penalty." He also alleged that Congress had offered "no legitimate basis whatsoever for its refusal to turn over" JMD's funds.

Relying on Truck Rent-A-Ctr. v Puritan Farms 2nd (41 NY2d 420 [1977]), Supreme Court concluded in July 2002 that "the liquidated damages clauses executed by the parties [were] so disproportionate from any potential damages suffered by Congress as to constitute an unenforceable penalty"; and that "Congress ha[d] not demonstrated that any issues of fact exist[ed] as to whether it [was] entitled to maintain a cash reserve" and "ha[d] not identified any additional obligations on JMD's part."⁵ Supreme Court referred the issue of the amount of money to be returned by Congress to JMD to a special referee, who in May 2003 awarded JMD $820,256.41 plus interest at the statutory rate of 9% per annum from December 1, 1999 through entry of judgment. In September 2003, Supreme Court entered an order and judgment accepting the special referee's determination and awarding JMD $1,098,090.41.

In October 2003, the Appellate Division affirmed Supreme Court's award of partial summary judgment to JMD (309 AD2d 645 [1st Dept 2003]). In March 2004, the Appellate Division affirmed Supreme Court's order accepting the special referee's determination (5 AD3d 334 [1st Dept 2004]). We subsequently granted Congress leave to appeal.

II.

This appeal principally involves a liquidated damages clause — the Agreement's provision for an early termination fee — considered by the courts below to be a penalty and therefore unenforceable. Whether the early termination fee represents an enforceable liquidation of damages or an unenforceable penalty is a question of law, giving due consideration to the nature of the contract and the circumstances (Mosler Safe Co. v Maiden Lane Safe Deposit Co., 199 NY 479, 485 [1910]; Leasing Serv. Corp. v Justice, 673 F2d 70, 74 [2d Cir 1982]). The burden is on the party seeking to avoid liquidated damages — here, JMD — to show that the stated liquidated damages are, in fact, a penalty (P.J. Carlin Constr. Co. v City of New York, 59 AD2d 847 [1st Dept 1977]; Wechsler v Hunt Health Sys., 330 F Supp 2d 383, 413 [SD NY 2004]). Further, "[w]here the court has sustained a liquidated damages clause the measure of damages for a breach will be the sum in the clause, no more, no less. If the clause is rejected as being a penalty, the recovery is limited to actual damages proven" (Brecher v Laikin, 430 F Supp 103, 106 [SD NY 1977] [citations omitted]; see also 3 Farnsworth, Contracts § 12.18, at 304 [3d ed] [where a liquidated damages provision is an unenforceable penalty, "the rest of the agreement stands, and the injured party is remitted to the conventional damage remedy for breach of that agreement, just as if the provision had not been included"]).

In Truck Rent-A-Center, we characterized liquidated damages as "[i]n effect, . . . an estimate, made by the parties at the time they enter into their agreement, of the extent of the injury that would be sustained as a result of breach of the agreement" (41 NY2d at 424). We called the distinction between liquidated damages and a penalty "well established":

"A contractual provision fixing damages in the event of breach will be sustained if the amount liquidated

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