COURT CLARIFIES 'MYSTERIOUS' RULE ON PENALTIES AND LIQUIDATED DAMAGES

June 24, 2004

Steven P. Garmisa
Hoey & Farina Attorney
garmisa@hoeyfarina.com
1-888-425-1212

Clarifying a murky area of Illinois contract law, the 7th U.S. Circuit Court of Appeals reversed a judgment holding that a liquidated damages clause was an unenforceable penalty. XCO International Inc. v. Pacific Scientific Co., Nos. 03-1683, 03-1825 and 03-2405 (7th Cir., May 24).

XCO International Inc. assigned its patents to Pacific Science Co. in return payment of $725,000, plus 5 percent of PacSci's sales of products that used the patents, with a minimum of $100,000 a year until the patents expired.

A liquidated damages clause provided that PacSci would pay $100,000 a year if PacSci breached the contract. And the contract also specified the damages if XCO breached the pact.

Another part of the contract required PacSci to pay the fees needed to keep the patents in force. But PacSci interpreted the contract as only requiring it to keep in force the patents it was using. As a result, PacSci let some of the patents expire.

XCO declared a default and filed suit in federal court, seeking $600,000 in liquidated damages. The trial judge agreed that there was a material breach of contract by PacSci, but he ruled that the liquidated damages provision was an unenforceable penalty.

Here are some highlights of Judge Richard A. Posner's opinion reversing the District Court (with various omissions not noted in the quoted text):

"When damages for breach of contract would be difficult for a court to determine after the breach occurs, it makes sense for the parties to specify in the contract itself what the damages for a breach shall be; this reduces uncertainty and litigation costs and economizes on judicial resources as well.

"Indeed, even if damages wouldn't be difficult to determine after the fact, it is hard to see why the parties shouldn't be allowed to substitute their own ex ante determination for the ex post determination of a court. Damages would be just another contract provision that parties would be permitted to negotiate under the general rubric of freedom of contract. One could even think of a liquidated damages clause as a partial settlement, as in cases in which damages are stipulated and trial confined to liability issues. And of course settlements are favored.

"Yet it is a rule of the common law of contracts, in Illinois as elsewhere, that unless the parties' ex ante estimate of damages is reasonable, their liquidated damages provision is unenforceable as a penalty intended to 'force' performance.

"The reason for the rule is mysterious; it is one of the abiding mysteries of the common law. At least in a case such as this, where both parties are substantial commercial enterprises (ironically, it is the larger firm, PacSci, that is crying 'penalty clause'), and where damages are liquidated for breach by either party, making an inference of fraud or duress implausible, it is difficult to see why the law should take an interest in whether the estimate of harm underlying the liquidation of damages is reasonable. Courts don't review the other provisions of contracts for reasonableness; why this one?

"It is true that if there is a very stiff penalty for breach, parties will be discouraged from committing 'efficient' breaches, that is, breaches that confer a greater benefit on the contract breaker than on the victim of the breach, in which event breach plus compensation for the victim produces a net gain with no losers and should be encouraged. (This is a reason why injunctions are not routinely granted in contract cases -- why, in other words, the party who breaks his contract is usually allowed to walk away from it, provided only that he compensates the other party for the cost of the breach to that party.)

"But against this consideration must be set the worthwhile effect of a penalty as a signal that the party subject to it is likely to perform his contract promise. This makes him a more attractive contract partner, since if he doesn't perform he will be punished severely. His willingness to assume that risk signals his confidence that he will be able to perform and thus avoid the penalty. It makes him a credible person to do business with, and thus promotes commerce.
"Granted, the case for a contractual specification of damages is stronger the more difficult it is to estimate damages and so the greater the expense to the parties and the judiciary, and hence to society, of determining the plaintiff's damages by the clumsy and costly methods of litigation. That presumably is why the enforceability of liquidated damages clauses depends on the difficulty of estimating, when the contract is signed, what the damages will be if the contract is broken.

"Yet in such cases the plaintiff will often be able to obtain injunctive relief instead of damages, on the ground that his damages remedy is inadequate, that being the standard criterion for injunctive relief; and an injunction often has a punitive effect because the cost to the defendant of complying with it will often exceed the harm to the plaintiff from the enjoined conduct.

"The fact that injunctions are sometimes granted in contract cases shows, therefore, that 'punishment' is not wholly alien to contractual remedies. At a minimum one might suppose penalty clauses tolerable to the extent that the penalty portion approximated the costs in attorney fees and other expenses of proving damages for breach of contract.

"The explanation for the rule against penalty clauses may be purely historical -- and 'it is revolting to have no better reason for a rule of law than that so it was laid down in the time of Henry IV.' O.W. Holmes, 'The Path of the Law,' 10 Harv. L.Rev. 457, 469 (1897).

"The slow pace at which the common law changes makes it inevitable that some common-law rules will be vestigial, even fossilized. When a person comes into court seeking relief, the court naturally is inclined to ask why it should get involved in the matter. The court is busy, its resources limited. It wants to see some potential benefit from judicial intervention before it will lift a finger.

"The rules of contract law have remote origins, predating the era of freedom of contract and the ideology of free markets. Thus, when parties to contracts first sought damages for breach in cases in which the contract when broken had still been executory, courts declined to oblige; they couldn't see what harm had been done when the victim of the breach hadn't yet paid anything or begun to perform. They were not moved by the fact that the parties, presumably rational, had thought it in their mutual interest to be able to enter into an enforceable executory contract.

"Similarly -- though here the historical record is murkier because there was an early period in which penal bonds were enforced -- courts have had difficulty seeing what benefit would be conferred by awarding in effect punitive damages for breach of contract. Because liability for breach is strict (though the strictness is somewhat ameliorated by such defenses as impossibility and frustration), contract breakers often are innocent in a moral sense. Breach of contract is not a tort, so should not be punished -- or so the reasoning goes.

"The rule against penalty clauses, though it lingers, has come to seem rather an anachronism, especially in cases in which commercial enterprises are on both sides of the contract. As we noted in Operating Engineers Local 139 Health Benefit Fund v. Gustafson Construction Corp., 258 F.3d 645, 655 (7th Cir. 2001), 'it is easy to assign non-exploitive reasons for contractual penalties and hard to give convincing reasons why in the absence of fraud or unconscionability consenting adults that are, moreover, substantial organizations rather than mere consumers should be prohibited from agreeing to such provisions.'

"The rule hangs on, but is chastened by an emerging presumption against interpreting liquidated damages clauses as penalty clauses.
"Whatever the strength and contours of the rule in Illinois today, PacSci is wholly in error in arguing that a liquidated damages clause is invalid unless it recites, or extrinsic evidence shows, that the parties determined that, yes, it really would be difficult to determine damages for breach after the breach occurred.

"No case in Illinois or anywhere else so holds or implies, and the rejection of the argument is implicit in the numerous cases that hold such clauses valid which do not contain such recitals, even when there is no extrinsic evidence to fill the gap.

"PacSci has tried to reverse the burden of proof, which, as in the case of other affirmative defenses, rests on the party resisting enforcement of a liquidated damages clause to show that the agreed-upon damages are clearly disproportionate to a reasonable estimate of the actual damages likely to be caused by a breach.

"The burden of proving the invalidity of the liquidated damages clause in the contract with XCO thus remained on PacSci, and it is apparent from the nature of the breach of contract -- failing to pay patent-maintenance fees, as a predictable result of which the patents lapsed -- that PacSci failed to carry it."

"About all the court could say would be that given the scale of XCO's operations, $100,000 a year from the breach to the termination of the last patent was not an outlandish estimate of the damages that XCO might sustain as a result of PacSci's allowing the patents to lapse. This case thus illustrates how a liquidated damages clause can spare the parties and the court the anxiety and expense of protracted and uncertain remedy proceedings.

"The element common to most liquidated damages clauses that get struck down as penalty clauses is that they specify the same damages regardless of the severity of the breach. One can see the problem: if a contract provides that breaches of different gravity shall be sanctioned with equal severity, it is highly likely that the sanction specified for the mildest breach is a penalty (that, or the sanctions for all the other possible breaches must be inadequate).

"That would have been the case here if instead of fixing the damages at $100,000 per year, the damages clause had recited for example that in the event of breach PacSci must pay XCO $500,000, period. Then if PacSci failed to pay only the maintenance fee due six months before the last patent expired, it would owe the same damages that it would owe had it never paid any of the maintenance fees and as a result all of XCO's patents had lapsed within a year after the contract was signed. That isn't how the clause works. Instead, by proportioning damages to the remaining life of the patents, it sanctions PacSci more heavily the longer the life that remained to them when PacSci allowed them to lapse.

"Yet the proportionality of the damages specification highlights by way of contrast the only halfway decent argument that PacSci has against the validity of the liquidated damages clause. This is that the clause fails to differentiate between different kinds of breach, some more serious than others, as distinct from different degrees of seriousness within a given kind.

"Suppose the breach had taken the form of PacSci's failing not to keep the patents in force but to make a royalty payment of $1,000 when it was due. The liquidated damages clause read literally would require PacSci not only to pay the $1,000 but to pay $100,000 on top of it for each year from the breach to the expiration of the last patent. That would be pretty outlandish -- depending on the date of breach it could cost PacSci more than $1 million though it had harmed XCO to the tune of $1,000 at most -- but it is an argument not for invalidating the clause but for interpreting it reasonably.

"It is apparent from the reference in the clause to the date of expiration of the last patent that the $100,000 a year damages provision is intended only for the case in which a breach by PacSci endangers the patents. It is not intended for other breaches, such as failure to pay agreed-upon amounts.

"Even if the clause were read literally, and as a result would be deemed a penalty if invoked in a case in which the breach consisted merely of a failure to pay royalties or other amounts due under the contract to XCO, the proper judicial remedy would be to reform the clause to limit it to those breaches, such as the one that occurred in this case, for which it constituted a reasonable specification of damages. There would be no reason to invalidate the clause in its entirety."

Finally, Posner noted, "After PacSci allowed XCO's European patents to lapse, a European company called Thermocoax started selling a product that competed with XCO's refractory-vessel cables (the major market for which is European), and as a result XCO's revenues plummeted by hundreds of thousands of dollars a year.

"XCO used this episode to argue that the liquidated damages clause was valid even if the clause didn't estimate damages reasonably at the time the contract was made, because it estimated them reasonably at the time of breach, and the trend in contract law is -- very sensibly, as it seems to us -- to allow a showing of ex post reasonableness to save the clause."

Back to Trial Notebook Main page