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Thursday, February 6, 2014

Indiana Court of Appeals on Liquidated Damages

This is the fifth in a series of posts that draw on Michael Dorelli and Kimberly Cohen's recent article in the Indiana Law Review on developments in contracts law in Indiana.   

Auburn_Auto_Historic_MarkerDefendant Dean V. Kruse Foundation (Kruse) operates a World War II and automobile museum in Auburn, IN.  It owned a property, but it could not generate sufficient income on the property to meet expenses, and so it sought to sell the property.   Plaintiff Jerry Gates (Gates) eventually purchased the property at auction for $4.2 million.  

The Purchase Agreement required a deposit of $100,000 in earnest money.  After voicing concerns about the property's condition and title, Gates terminated the Purchase Agreement.  Kruse threatened that it would seek specific performance.  Eventually, it sold the property to a third party for $2.35 million.  

Gates eventually sued Kruse and its realtor for breach of contract, fraud and conversion.  Kruse counterclaimed for breach of contract and slander of title.  The trial court granted summary judgment to Gates and ordered Kruse to return the earnest money with interest.  The Indiana Court of Appeals reversed and remanded with instructions to enter summary judgment in favor of Kruse and to hold a hearing on damages.  At that hearing, Kruse sought damages of about $2.5 million plus prejudgment interest.  The damages represented the difference between the contract price and the price on resale.  Kruse also sought a $200,000 buyer's premium that was part of the Purchase Agreement, but was willing to set off the $100,000 earnest money against the amount owed.  

The trial court determined that the provision for $100,000 in earnest money was a liquidated damages clause.  Kruse had the additional option of suing for specific performance, but it did not do so.  The trial court therefore held that its dmaages were limited to the $100,000.  Kruse appealed.  In Dean V. Kruse Foundation v. Gates, the Court of Appeals once again reversed the trial court and remanded with instructions.

Kruse argued that the liquidated damages clause was in fact an impermissible penalty clause, among other reasons because the Purchase Agreement provided for specific performance.  Under Indiana Law, "liquidated damages clauses are generally enforceable where the nature of the agreement is such that damages for breach would be uncertain, difficult, or impossible to ascertain."  After reviewing relevant precedents, the Court of Appeals concluded that the clause at issueindicated an intent "to penalize the purchaser for a breach rather than an intent to compensate the seller in the event of breach."  The first prong of the test thus suggested a penalty clause.

The Court next considered whether the alleged penalty was disproportionate in relation to the amount to be lost in case of breach.  The Court could not determine whether it was at the time Gates bid on the property.  Liquidated damages clauses are used where the potential harm is uncertain.  So, the question was whether or not damages were uncertain.  Incredibly, the Court of Appeals found that they were not, because there was expert testimony presented that the market value of the property at the time of the breach was $3.5 million.  

Huh?  The property sold once for $4.2 million and then again for $2.35 million.  Since the parties could not know in advance when a breach would occur, and factual record reveals that the value of the property fluctuated considerably, to say that the parties could have known in advance the harm that would result from a breach seems quite fanciful.  Nevertheless, the Court of Appeals struck down the earnest money provision as a penalty clause.  

Kruse also argued on appeal that its remedies were not limited to the liquidated damages provision and specific performance.  The Court agreed, since the parties had not expressly limited their remedies.  

The outcome of the case is that Kruse retained all of its contractual remedies except for the two clearly provided for in the Purchase Agreement: the earnest money, which was struck down as a penalty, and the right of specific performance, which Kruse chose not to exercise.  This all seems quite backwards.  If it was a penalty clasue, it was a penalty clause that protected Kruse's interest in forcing Gates to stick with the deal.  If the penalty proved inaccurate, it seems quite odd that Kruse should have standing to argue that the penalty it imposed was inappropriate.  I have never heard of a penalty clause being struck in favor of a claim for damages 25 times higher than the alleged penalty.

The case was remanded back to the trial court again for a calculation of damages.

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