ContractsProf Blog

Editor: Jeremy Telman
Oklahoma City University
School of Law

Thursday, May 2, 2024

Various Problems with Liquidated Damages

Posner_richard_08-2010I use Judge Posner's opinion in Lake River Corp. v. Carborundum Co. to teach liquidated damages and penalties.  It's a typical Judge Posner (left) opinion.  He provides policy arguments for and against the enforcement of liquidated damages provisions, even if they impose a penalty on the breaching party.  Judge Posner makes the compelling freedom of contract/anti-paternalist arguments in favor of enforcement of penalties, assuming relative sophistication and comparable bargaining power.  Against these arguments, he offers the theory that deterring opportunistic breach prevents efficient breaches that produce better outcomes for most of the parties involved and do not produce worse outcomes for any of them (assuming no transactions costs).  He then heaves a sigh, says, "Illinois, ya basic!" and applies the applicable state law prohibiting the enforcement of penalties. 

Some of my students wanted to outflank Judge Posner.  Yes, the liquidated damages clause in the contract was absurd, but why should a court come to the rescue of a well-resourced party that entered into a bad deal with eyes wide open?  Carborundum apparently valued access to Lake River's bagging and distribution capabilities so highly that it was willing to take on a high penalty for breach.  My students could have cited another Judge Posner case that I also teach, NIPSCO v. Carbon County Coal.  There, NIPSCO entered into a long-term contract to buy coal whether or not it needed the coal.  NIPSCO assumed that it would need the coal when it entered into the contract, but then it became significantly less expensive to get electricity from other sources. The state regulatory authority would not allow NIPSCO to pass on to its customers the costs it incurred through its lack of foresight, and so it sought to get out of its contractual obligations.  Judge Posner would not allow it to do so, even though the effect was quite similar to a penalty clause.  NIPSCO had to pay an inflated price for coal it didn't need.  Indeed, according to Judge Posner, nobody wanted the coal, which was why the mine shut down once NIPSCO stopped accepting shipments.  

So, Judge Posner would not force Carborundum to pay for bagging and distribution services it no longer needed, but he did force NIPSCO to pay for coal it didn't need.  The cases are reconcilable as a matter of legal doctrine.  In both cases, I find Judge Posner's legal reasoning entirely persuasive. And yet, their outcomes seem hard to square with both economic theory and the principles of freedom of contract.  Perhaps the solution is that Judge Posner, if unconstrained by the Erie doctrine or precedent, would simply allow the parties' terms, no matter how ill-conceived, to govern in both cases.

SepinuckProfessor Stephen Sepinuck (right), a keen-eyed scanner of the legal horizon, noticed another liquidated damages conundrum.  Ne. Ill. Reg'l Commuter R.R. Corp v. Judlau Contracting, Inc., involved a $17 million contract for construction work on Chicago's Metra line.  Judlau did not complete the project within the time specified in the contract, running over by 500 days.  Metra alleged a right to choose between enforcing the contract's liquidated damages provision and seeking actual damages.  District Judge Mary Rowland of the Northern District of Illinois, noted that Illinois law does not permit parties to choose between actual and liquidated damage, and she rejected Metra's attempt to distinguish between a right to collect liquidated damages an option to choose between liquidated and actual damages. 

Metra acknowledged the Illinois prohibition on clauses that permit a party to choose between liquidated and actual damages, citing Karimi v. 401 North Wabash Venture, LLC.  The Illinois rule struck Professor Sepinuck as unusual.  Learned commentary ensued.  Indeed, Colorado reached the opposite conclusion in Ravenstar, LLC v. One Ski Hill Place, LLC.  The Illinois rule seems to be motivated by a horror of penalty clauses.  Confronted with little or no actual damages, the non-breaching party can nonetheless profit from a liquidated damages clause.  Facing actual damages well in excess of liquidated damages, the party might choose to jettison the limits imposed by the liquidated damages clause.  It creates a win/win for the non-breaching party and also eliminates one of the primary advantages of a liquidated damages provision -- the ability to settle a claim quickly without the need to prove actual damages.

Which brings us back to Judge Posner's dilemma.  These option clauses seem ill-advised.  Why agree to a liquidated damages clause designed to  minimize litigation costs while also giving the other party the option to choose to impose litigation costs on you?  However, if sophisticated parties agreed to an ill-advised clause  why not allow them to be hoist by their own petard?  In Judlau, the court faced no such dilemma, Judge Rowland concluded that "the plain language of the contract here does not create an option between liquidated and actual damages."  Metra did not include an ill-advised option clause in its contract.  It just seems to have pursued an ill-advised litigation strategy that involved arguing without much of a textual basis that it had negotiated for an advantageous option which, it acknowledged, was foreclosed in any case by governing law.

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Posner mischaracterized the Lake River contract. Lake River promised to stand ready to process 400 tons per week for 3 years at a fixed price. Carborundum promised to pay for about one third of that maximum regardless of whether it took anything at all; it was free to price shop or send les than 22,000 tons for any reason. Lake River fully performed—it had been ready for all three years. This was a take-or-pay contract, despite Posner’s claim otherwise.

Posted by: victor goldberg | May 2, 2024 5:44:18 AM

So it sounds like Judge Posner could have done in Lake River what he did in the NIPSCO case. Any idea why he didn't? Might it have had to do with the way the parties (mis)characterized their own agreement?

Posted by: Jeremy Telman | May 2, 2024 7:02:32 AM

I can't remember why, but almost twenty years ago, there was a discussion of Lake River on some forum, perhaps the AALS Contracts list-serv. I had just engaged with Judge Posner over his "The Law and Economics of Contract Interpretation" (Texas L. Rev.), and wrote something that Bruce Frier and JJ White ended up putting in their teacher's manual for "The Modern Law of Contracts." It takes a different angle. I've edited it from the version in the manual:

"Based on an article [he wrote] some years [after Lake River], there is an argument Judge Posner was not so much concerned about the issue of liquidated damages, but contract drafting that so poorly reflected the business realities as to appear to be a mistake. Judge Posner’s comments on mistake seemed to reflect situations like Lake River: 'What the cases that allow rescission on the ground of "mutual mistake" are really about is a demonstrable real-world fact that makes a semantically unproblematic contract either insolubly ambiguous or nonsensical.' Judge Posner contends there is a functional relationship between the cost of good drafting (consistent with rational actor theory) and the later cost (including the use of the courts) of dealing with ambiguous or erroneous drafting. Thus, sophisticated parties who assert a badly drafted clause ought to lose. Is it possible Judge Posner viewed not so much as the contract clause having constituted a penalty, but as having been a badly drafted penalty (i.e., potentially inefficient and not commonsensical - see below).

"Judge Posner often equates efficiency with common sense; indeed that is the basis for his jurisprudence of pragmatism. Most people don't enter into one-sided agreements. If the interpretation of an agreement makes it one-sided, that interpretation is probably wrong. 'That would be a reason - call it common sense or, if some explicit economic reasoning is employed, the promotion of efficiency - for the judge to choose the other interpretation.' Indeed, a bit later in the article, Judge Posner quotes his own cases to the effect that a contract will not be interpreted literally if doing so would produce absurd results, in the sense of results that the parties, presumed to be rational persons pursuing rational ends, are unlikely to have presumed to seek. It is clear that Judge Posner did not think the clause in Lake River was commonsensical. He demonstrates that if the costs of performing were avoided, Lake River was actually far better off in the circumstance of a breach.

"It seems clear as well that it was not the legal theory of liquidated damages but his view of what looked like a nonsensical contract that drove Judge Posner’s opinion. Later in the opinion, he rejects an analogy to take-or-pay contracts, which are common in the supply of raw materials to utilities, and often enforced. There again his view of the fixed versus variable costs was critical; he distinguishing take or pay contracts in which there is a huge front end investment compared to the small ongoing variable cost. In his article, Judge Posner stated, 'businessmen are not literalists. They do not have the lawyer's exaggerated respect for the written word and thus do not expect bizarre consequences to follow from mistakes in drafting. . . .Businessman [sic] would, I am speculating, like judges to resolve interpretative issues the way a reasonable businessman would.'

"If the parties in fact offered up penalty versus liquidated damages as the issue, did it provide Judge Posner with the most pragmatic route to where he likely believed reasonable businessmen would have wanted this issue to land - on a more traditional calculation of expectation damages, measured by the lost investment plus the lost profits? Without any evidence to support mutual mistake, he would have been rewriting the unambiguous words of the contract. So he deemed it a penalty and his view of the common sense result prevailed. Is this an appropriate outcome? Do you think businesspeople would rather have their language interpreted literally or according to a judge’s view of what a reasonable business outcome should be? Does it seem just as plausible that Carborundum was trying to weasel out of a clear agreement to cover allocated fixed costs in addition to cost of the bagging machine, and that Lake River’s lawyers did a poor job explaining there was no windfall? Is Lake River a better case for a 'four-corners' approach or a contextual approach to contract?"

Posted by: Jeff Lipshaw | May 2, 2024 8:21:54 AM

Is it too late to pick the blue pill?

Posted by: Jeremy Telman | May 2, 2024 8:49:50 AM

Posted by: Jeff Lipshaw | May 2, 2024 10:30:20 AM