In this lecture, I'm going to discuss liquidated damages and agreed remedies. And then, we'll look at the cellphone termination fee cases from California in 2011. One underlying principle we have seen throughout this course is a strong preference in contract law to compensate the plaintiff instead of to punish the defendant. That's why there are severe limitations on punitive damages in contract cases. It's also why we're seeing that courts are reluctant to enforce conditions that work forfeitures on defendants. The same tendency can be seen when a contract involves liquidated damages. That is, when a contract contains a provision setting out what the damages should be for particular types of breaches. If liquidated damages serve as a "penalty or forfeiture clause," courts will not enforce them, considering them to be unconscionable or against public policy. A clause which liquidates damages at an unreasonably high amount is sometimes referred to as an in terrorem clause. These pound of flesh provisions are not enforced because they place the promisor in terror or fear that she may not be able to perform. A standard formulation of the rule concerning enforceability appears in Judge Kaufmann's opinion from a case called Leasing Services Corporation versus Justice which found that liquidated damages are enforceable only "if the amount liquidated bears a reasonable proportion to the probable loss and the amount of actual loss is incapable or difficult of precise estimation." These liquidated damage provisions will not be enforced if they are "plainly or grossly disproportionate to the probable loss." These criteria are often met in situations where a company has many individual contracts of the same type, and it knows it's average loss per breach but it's hard for the company to determine the exact number of lost dollars corresponding to each particular breach of contract. Section 2-718 of the Uniform Commercial Code incorporates these same principles. As you can see, the amount of the damage has to be "reasonable in the light of the anticipated or actual harm." They cannot be unreasonably large. They also must be justified by the difficulties of proof of loss corresponding to the idea that the actual loss from the breach of a particular contract must be difficult to calculate. The second restatement section on liquidated damages is quite similar. Economists have severely critiqued the doctrine on liquidated damages, the doctrine refusing to enforce many of these provisions. The economist's arguments fall into three main categories. The first argument is that parties are rational. In bargaining for a contract, they negotiate many provisions, but ultimately sign the contract if it's to their advantage. If parties sign a liquidated damage provision, they must've gotten something else at least as valuable in exchange, so we should generally enforce contracts that will tend to make parties better off. The next and related argument is that the parties know more about the value of losses they incur if there's a breach than the court does. They should be allowed to set liquidated damages based on that private knowledge without the court coming in later to second guess their decision. And finally, the doctrine on liquidated damages prevents the parties from shifting risk. For example, if parties set liquidated damages for a seller's breach to be more than the buyer's cost for covering transaction, that prevents the seller from getting all of the upside risk of a better opportunity coming along. The liquidated damages clause gives the buyer a bargaining chip to negotiate for part of the gain. Under the current doctrine, it would be much more difficult to shift any upside risk to the buyer. For these reasons, economists have suggested that courts should simply enforce liquidated damage provisions as written, unless there is a procedural reason to think that the parties did not consent. You might still strike down clauses that were procedurally as well as substantively unconscionable, but you wouldn't strike them down merely because courts felt one side was buying too much insurance. State courts have varied in the extent to which they've engaged with these economic arguments with some being more willing to enforce liquidated damage provisions than others. This should not give you the sense that parties have no ability to contract about the results of a suit for breach of contract. Parties may generally specify what sorts of remedies will be available. Section 2-719 of the UCC sets out one version of this kind of regulation. It allows parties to set out additional remedies beyond those the UCC generally makes available or to substitute their own preferred remedies for the UCC's remedies. Under sub section three of this provision, which is omitted from this slide, they can even disallow consequential damages. Subsection two, however, ensures that the non-breaching party will always have an effective remedy. If the substitute remedy "fails of it's essential purpose, the general UCC remedies spring back into life and are available as a fallback option." Let's look at one case dealing with a kind of liquidated damage provision, a kind that to which many of you have been subject. The Cellphone Termination Fee Cases from California in 2011 dealt with early termination fees charged by Sprint to customers who end their cell phone service contract before the term is up. These pictures should give you a quick reminder of what cellphones looked like back when this case was decided. Back in the 1990's, Sprint found that it had excessive churn in it's cell phone customers. That means, too many customers were backing out of their contracts and going with other providers. In 2000, it introduced an early termination fee of $150 and saw a significant decrease in churn. In 2005, it increased the termination fees to $200 over the period covered by this case, which is a class action on behalf of California Sprint customers. It managed to collect nearly $74 million in early termination fees from just it's California customers. The trial court found the early termination fee to be an unlawful penalty, and so it enjoined Sprint from continuing to collect it and awarded damages of the full amount collected. But the jury had also found that the actual damages to Sprint were more than $225 million equal to the amount of unpaid early termination fees which indicated that they had misunderstood the question and the testimony. And so the court ordered a partial new trial on that question and on how to set off those damages against the amount collected. Both parties appealed. We're now reading Justice Bruinier's opinion from the First District California Court of Appeals. He considered the question of whether Sprint's early termination fees acted as invalid liquidated damages. The court applied a two-part test to determine whether the early termination fees served as a penalty and was therefore unenforceable. This two-part test is similar to the statement we saw earlier by Judge Kaufman, but is not quite identical. The first part should look familiar. It must be impracticable or extremely difficult to determine the amount of damages. Here, the trial court had found that it was very difficult to calculate Sprint's avoidable costs from any given termination, and so, Sprint passed this first test and the plaintiffs didn't dispute that. Sprint failed the second part, however. This required not merely as Judge Kaufman and the UCC had it that liquidated damages be reasonable, rather, the amount of the damages must have been set by a reasonable endeavor to determine what is fair compensation for the loss. It's not enough that the amount be reasonable, but the process to reach that amount must have been based on an estimation of actual damages. Here, Sprint failed. It set the amount with an eye toward reducing churn by imposing penalties on customers who left, not with an eye toward compensating itself for their lost business. This result doesn't seem entirely fair. Based on the court's discussion of the facts, it seems quite likely that Sprint's actual losses may have been larger than the amount it assessed in early termination fees. Should it really be prevented from recouping it's actual losses because it used an improper process to set liquidated damages that turned out to be too low? In any event, that is how the court ruled. Sprint tried to argue that it's fees were not a penalty, but rather, an alternative mode of performance. Under Sprint's theory, customers may fulfill their obligation either by sticking with their phone plan or by paying the fee as an alternative performance. But the court didn't buy this argument. They found that the contract allowed Sprint to impose the fee involuntarily on customers to pay the fee when Sprint decided to terminate their contracts when the customers failed to pay their bills, which meant that the fee behaved much more like a penalty than an alternative performance that the customers themselves could choose. Justice Brunier would not allow Sprint to "indirectly accomplish in this way something that the legislature intended to prohibit." All right. Well, let's go to a quiz. Sheila runs a rental car company and customers often return cars late which often hurts her business because she has no car available for the next customer. She knows that these loses her on average $100,000 per year and that 500 cars are returned late each year. What would be an acceptable amount for liquidated damages for a late return? Well, Sheila can probably set liquidated damages at $200 and have them be enforced. This is a situation where it is hard to estimate exactly what the cost is from any given late car because the individual rental cars aren't associated with particular customers in advance. $200 "bears a reasonable proportion to the probable loss" because it's equal to the aggregate loss of $100,000 divided by the number of incidents that contribute to that loss which is 500. That is, a late return, on average, costs Sheila $200. But it's difficult to say which late returns cause precisely what proportion of those losses. In this lecture, we've seen that liquidated damages clauses set the amount of damages for breach in advance and in explicit provision of the contract. Courts will enforce them when they satisfy two main criteria. First, they must be reasonably related to the amount of actual losses. And in California, they must actually be set based on such a calculation. Second, it must be difficult to calculate the actual losses. So, the setting of liquidated damages in advance serves a useful function. But also, keep in mind the economic critiques we saw which suggests that even penalties should be enforced as long as they are adequately disclosed.
