Teaching Assistants: The Problem of Liquidated Damages in Carborundum

This is the sixth in a series of posts on Victor Goldberg's work.  Today's post is about Chapter 7 of his book, Rethinking Contract Law and Contract Design (RCL).  Links to other posts follow this post.

In Lake River Corp. v. Carborundum, Lake River invested $89,000 in a bagging machine so that it could bag Carborundum’s product.  Over a three-year period, Lake River was to bag at least  22.5 tons of Ferro Carbo for a fixed contract price of $533,000.  In order to protect Lake River’s investment, the parties agreed that, even if Carborundum sent less than the contractual minimum of Ferro Carbo for bagging, it would still pay the contract price.  Carborundum did not provide the minimum quantity for bagging, and Lake River sought to enforce what the parties and the courts treated as a liquidated damages clause.  Judge Posner, while of course expressing his skeptical view of the bar on excessive liquidated damages, did what the common law of Illinois required.  Having calculated Lake River’s damages under the liquidated damages clause as exceeding damages flowing from breach regardless of when the breach occurred, Judge Posner dutifully struck the clause as a penalty (RCL, 71-77).

One might expect Professor Goldberg to criticize the case for confining sophisticated parties to the procrustean bed of traditional common-law remedies.  They bargained for a price for Carborundum’s breach.  Why shouldn’t the courts enforce that option price?  But that is not his only take-away from the case.  This is another case where the courts failed to understand the facts and thus the economics behind the deal.  No shade on Judge Posner; the parties did not understand their own deal, and Judge Posner had to work with what he had. 

When we look at additional clauses from the contract, which was an appendix to Lake River’s brief, we see that Carborundum paid for flexibility.  If it needed Ferro Carbo bagged, Lake River stood ready to do so.  Because Lake River had incurred costs, it demanded a minimum payment of $533,000.  If it bagged more than 22.5 tons of Ferro Carbo, it would be paid more.  But Lake River's costs were not limited to the $89,000 bagging machine.  It set aside space at its plant, it hired additional personnel to run the bagging operation, and it was constrained in its allocation of resources because it had to stand ready, for three years, to bag up to 400 tons of Ferro Carbo per week (RCL, 77-79).  Such costs are very difficult to calculate and thus are an appropriate subject matter for a liquidated damages provision (RCL 80-81).  That is especially the case here, where Carborundum did not provide notice of anticipatory breach; Lake River never had an opportunity to offset its damages with the resources it could have freed up had it received such notice (RCL, 82-83).

Judge Posner (left) considered but rejected the idea of treating this case as similar to “take-or-pay” provisions we see in extractive industries.  Such provisions are appropriate, Judge Posner reasoned, only when the supplier’s fixed costs constitute a large fraction of the total costs.  Professor Goldberg disagrees.  High fixed costs are a sufficient but not a necessary ingredient of take or pay provisions (RCL, 81).  I wonder whether pay-or-play provisions, discussed in chapter 2 of the book. provide a useful analogy.  Sandra Locke did not have high fixed costs in her deal with Warner Brothers, but had Warner Brothers breached by not paying her the $1.5 million owed under their agreement, the courts would not have allowed Warner to argue that the contract price was an unenforceable penalty clause.  In a typical pay-or-play scenario, the payor wants to have the payee available, and they may also want to render the payee unavailable to rivals.  Flexibility is a contractual right for which one can bargain.  Carborundum seems to have bargained for such a right here, and the so-called liquidated damages clause represents the price that Lake River demanded to protect its reliance interest.

Professor Goldberg concludes that the $533,000 contract price and minimum quantity clauses were not damages provisions but simply set the price for the service Lake River provided, for a three-year period, to Carborundum.  However, as noted above, even if the clauses were treated as liquidated damages provisions, they should have been upheld.  Here, as in many cases, Professor Goldberg advises, courts should get out of the way when sophisticated parties create their own remedies (RCL, 83).

A post on Chapters 5 & 6 (speculative damages) is here.

A post on Chapter 4 (lost-volume damages) is here.

A post on Chapter 3 (timing for assessing damages) is here.

A post on Chapter 2 (the flexibility/reliance trade-off) is here.

The introductory post is here.