Stipulated damages, super-strict liability, and mitigation in contract law

Michigan Law Review

Volumn 107, Issue 8, 2009, Pages 1365-1380

  Levmore, Saul ^a  

^a UNIVERSITY OF CHICAGO LAW SCHOOL   (United States)

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EID: 66749088314     PISSN: 00262234     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (53)

1. It once would have been enough to cite L.L. Fuller & W. R. Perdue, Jr., The Reliance Interest in Contract Damages, 46 YALE L.J. 52, 59-62 (1936) (expectation must be protected to "promote and facilitate reliance on business agreements"), but specific performance and actual damages would, of course, also protect reliance. Eventually, even the most doctrinal voices came to see expectancy damages as the means by which American courts normally choose to encourage reliance on promises.
2. See 3 E. ALLAN FARNSWORTH, FARNSWORTH ON CONTRACTS §12.1, at 149-150 (3d ed. 2004).
3. For example, specific performance applies to contracts for unique goods, U.C.C. § 2716(1) (2005),
4. including transfers of interests in specific land. RESTATEMENT (SECOND) OF CONTRACTS § 360 cmt. e (1981);
5. RESTATEMENT (FIRST) OF CONTRACTS § 360 (1932).
6. See U.C.C. § 2-718(1) (referring to reasonableness in light of the "anticipated or actual" harm or loss, and the difficulties of proof and of otherwise obtaining a remedy for breach); RESTATEMENT (SECOND) OF CONTRACTS § 356.
7. The distaste for penalties may be related to the desire to prohibit gambling, but my strategy here is simply to accept the old results-and then to recharacterize the law in this area.
8. See Lake River Corp. v. Carborundum Co., 769 F.2d 1284, 1287 (7th. Cir. 1985)
9. (Posner, J.) ("If the contractual specification of damages is invalid, Lake River still is entitled to any actual damages caused by Carborundum's breach of contract...."); FARNSWORTH, supra note 1, § 12.18, at 304
10. ("If a provision is condemned as a penalty, it is unenforceable. But the rest of the agreement stands, and the injured party is remitted to the conventional damage remedy for breach of that agreement, just as if the provision had not been included.").
11. The subject was shown to be interesting in Elizabeth Warren, Formal and Operative Rules Under Common Law and Code, 30 UCLA L. REV. 898 (1983).
12. The conventional view, however, continues to be that underliquidated- damage provisions present the completely different problem of unconscionability, if they present any problem at all. See U.C.C. §§ 2-302, 2-718 cmt. 1 (stating that unconscionability is the means of striking underliquidated damages).
13. See generally Charles J. Goetz & Robert E. Scott, The Mitigation Principle: Toward a General Theory of Contractual Obligation, 69 VA. L. REV. 967 (1983).
14. For example, were B to destroy the apartment, we would expect A to be able to collect more than $1500 from. B, and if damage done by B were modest, we would expect B to get some of the deposit returned. This must be true even if the parties have sloppily or inconceivably written that their "deposit" is the exclusive remedy for damage. One way to think about the occasional judicial distaste for liquidated damages is to see that nearly all stipulations can beget overliquidation, with its risk, of wasteful behavior. See Kenneth W. Clarkson et al., Liquidated Damages v. Penalties: Sense or Nonsense?, 1978 Wis. L. REV. 351, 369-372 (analyzing situations where breach inducement is more likely, and emphasizing the inefficiency of such inducement).
15. Courts might strive to get at this problem by denying "penalty damages" even, when the parties seem to have priced the danger in their contract, by looking directly for wasteful behavior in the cases before them, or by rejecting penalty clauses as a prophylactic measure to save themselves the burden of ferreting out antisocial behavior even when there is no evidence of it. Alternatively, if we accept the idea that stipulated damages amount to a strong form of strict liability, we might draw on the literature that celebrates the efficiency of strict liability with a contributory negligence defense. If a court were to enforce this $1500, penalty-looking provision, it might be expected to do so only where there was no hint or evidence of contributory negligence on the landlord's part. This is not quite the efficiency formula suggested by Clarkson et al., but it is close;
16. if either party does have opportunity and might have incentive, the clauses should be enforced only if they are reasonable in relation, to the damages sustained. Id. at 352. An inquiry into the landlord's behavior seems straightforward; indeed it may seem implausible that most landlords could increase the likelihood that their tenants would inflict modest damage, beyond normal wear and tear. But it might be a small additional step to wonder whether a court might not look at the tenant's mitigation efforts.
17. See U.C.C. § 2-719(l)(b) (2005) (noting that provided remedies are optional "unless the remedy is expressly agreed to be exclusive, in which case it is the sole remedy."). Comment 2 emphasizes the point in clearer language: "If the parties intend the term, to describe the sole remedy under the contract, this must be clearly expressed." Id. § 2-719 cmt. 2. In the landlord-tenant case, the duty to mitigate is a modern development, modifying the landlord's ability to leave the premises vacant and collect the remaining rents. 2
18. RICHARD R. POWELL, POWELL ON REAL PROPERTY § 17.01 (Michael Allan Wolf ed., 2008). Statutes emphasize expectancy damages and give no support for the convention that the landlord's exclusive remedy is the deposit. See, e.g., CAL. CIV. CODE § 1951.
19. 2(a) (West 1985) (discussing the landlord's right to unpaid rents, subject to mitigation). More generally, when parties liquidate damages, they sometimes, but not always, indicate that their assessment represents an exclusive remedy in the event of breach. See infra text accompanying note 12.
20. There are also cases where the stipulated damages reflect the reimbursement of an upfront discount in order to induce a contractual relationship. For example, a cell phone owner might receive a discounted telephone at the start of a service contract, but owe a fixed amount in the event of early termination. Similarly, an employee might receive a signing bonus, with the provision that a significant amount is owed if the employee departs within a specified number of years. These sorts of payments fit in the present analysis, but they can be set aside as reimbursements, and in any event they do not implicate mitigation. In all three cases-residential leases, bounced checks, and cell phone contracts-I resist the explanation that the breacher is expected to be judgment proof, or that it does not pay to bring legal action. After all, landlords and tenants regularly sue over unretumed or insufficient damage deposits.
21. In contrast, a nonprofessional, low-volume landlord might have more success pursuing expectancy damages.
22. For an earlier observation of this point, that a fixed damage term, can encourage optimal mitigation by one party, see Richard A. Epstein, Beyond Foreseeability: Consequential Damages in the Law of Contract, 18 J. LEGAL STUD. 105, 117 (1989).
23. In the case of commercial real estate, and in other settings, the understanding may be different, and I do not mean, to overgeneralize. It is sufficient to see that stipulation can and does play the roles described here.
24. These questions could arise even if only the deposit were at issue, as B would likely argue that the deposit is a ceiling on damages.
25. Of course, to the extent the litigation costs associated with expectancy damages' comparative-fault regime are very high, the apparent superiority of that scheme disappears.
26. Thus, in the example in the text, the $2000 deposit is owed without any inquiry into mitigation, but it is less than, strict liability in the sense that it offers only $2000, rather than the $24,000 that an expectancy-damage remedy might generate. For a case where stipulation, provides super-strict liability, does not depend on mitigation (though it is likely efficient), and also should have avoided litigation over mitigation and damages, see Barrie School v. Patch, 933 A.2d 382 (Md. 2007), in which the court enforced stipulated damages of entire year's tuition where parents withdrew student from private school after specified date of May 31.
27. There is also the idea that stipulation may obviate the need to reveal proprietary information. See Omri Ben-Shahar & Lisa Bernstein, The Secrecy Interest in Contract Law, 109 YALE L.J. 1885, 1890-91 (2000) (describing a variety of contexts in which parties may avoid default rules or litigation in order to protect valuable information). The advantages to some parties of super-strict liability may thus supplement not only the self-assessment function, of stipulation but other advantageous functions.
28. Aldon Indus., Inc. v. Don. Myers & Assocs., 517 F.2d 188 (5th Cir. 1975).
29. The court declined to go along with a "general rule" that the anticipated profits of a commercial business ought always be regarded as too speculative, but it did say that, where anticipated profits are concerned, a plaintiff has a difficult burden of proof. Id. at 191 (quoting New Amsterdam Cas. Co. v. Util. Battery Mfg. Co., 166 So. 856, 860 (Fla. 1935)).
30. For another case where damages were thought too speculative, but where parties can be seen as having engaged in a kind of stipulation, see Freund v. Washington Square Press, Inc., 314 N.E.2d 419 (N.Y. 1974), in which the court reduced damages to six cents because there was no reliable way to determine the lost book, sales or, derivatively, the author's lost royalties from publisher's failure to publish, where the author had received a $2000 advance.
31. 265 Ill. App. 542, 549 (1932).
32. See, e.g., Drews Co. v. Ledwith-Wolfe Assocs., 371 S.E.2d 532 (S.C. 1988) (finding insufficient certainty to award lost profits but deciding to join the majority of jurisdictions in applying the "new business rule" as a rule of evidentiary sufficiency and not as an automatic preclusion to recovery of lost profits by a new enterprise).
33. See, e.g., XCO Int'l, Inc. v. Pac. Scientific Co., 369 F.3d 998 (7th Cir. 2004) (upholding $100,000 per year in liquidated damages where assignee allowed assignor's patent to expire, and noting that it was sensible for parties to stipulate damages where damages are difficult to determine).
34. Note that courts are not simply saving themselves work in one place, damage assessment, in order to take it back on when evaluating claims that stipulated amounts should be excluded as "penalties." The latter inquiry is more relaxed as courts need not be precise in order to rule whether penalties have been provided.
35. And "knowledge" might be understood to include the protection of knowledge, as emphasized by previous commentators. See Goetz & Scott, supra note 6 (emphasizing throughout the problems of private knowledge and cooperation); see also infra note 24.
36. See supra text accompanying note 15.
37. In practice, parties inclined to stipulate damages in order to avoid litigation over mitigation will surely want to avoid litigation about expectancy damages, where they also enjoy a knowledge advantage. The reverse is less obvious. Parties may wish to exploit their own knowledge and take the determination of expectancy damages away from the court, but they may still fear losses from the failure to mitigate enough to tolerate litigation over those losses. Careful stipulation will help. For example, the carpet manufacturer (which may know its product is defective in time for dealers to stock, other inventory), Dempsey, and surely the tenant, B, can all be encouraged to reveal coming breaches early in the game just as the withdrawing law student has an incentive to do, with clauses that increase their damages as the revelation date is delayed. In some settings, parties turn to insurance, but this does not mar the point about bundling mitigation and knowledge. Thus, when a construction company is employed to build a bridge or renovate a place of business, the customer fears delay or abandonment. It might obtain or require a performance bond, and include that premium in the price of the contract. The surety's price is one check on the feasibility of the project, and on the schedule of payments due from the customer, because it must stand ready to hire another firm, to complete the project. Concurrently, the construction company may buy or require a payment bond, so that each side's performance under the contract may be guaranteed. If the project is abandoned by the construction company, the customer (and the insurer with a right of subrogation) may make a claim for this breach. Under these circumstances, stipulation may be less attractive. The parties might respond to the unavailability of expectancy damages by demanding these sureties, and so we can think of the premium, paid to an insurer as a kind of stipulated damages, but paid ex ante. This is surely a form of super-strict liability, where payment follows the activity rather than the breach.
38. 764 P.2d 149 (Okla. 1988). A well known outlier is Samson Sales, Inc. v. Honeywell, Inc., 465 N.E.2d 392 (Ohio 1984), where a similar liquidated damages clause was thrown out as a penalty, both because it was not a reasonable estimate of damages and because damages would normally be easy to ascertain. The parties' language was perhaps unfortunate, and the court might have treated the clause differently had it been fashioned as a limitation on liability. Fretwell also raises the issue of a clause fashioned as liquidated damages, but treated by the court as involving a limitation on liability, and therefore not subject to the claim, that it was an inapt estimate of damages.
39. Fretwell, 764 P.2d at 150.
40. Some readers will be satisfied with the extant explanation and require neither knowledge nor mitigation to do any of the heavy lifting in these cases. For example, causation may be an issue because the crime might have been completed before a response team could have reached the site. Alternatively, the parties might agree on zero damages because the homeowner is normally insured. Finally, they may sense that, without the limitation, it will be too difficult to price the security services ex ante, and a kind of adverse selection will drive the price too high. For more on the underliquidation concern, see generally Warren, supra note 5.
41. If some disclosure by N would be useful, as when N learns of a problem from other users, it is possible that the contract or legislation will step in. to encourage disclosure, or mitigation. Moreover, where damages include personal injury, as is the case where automobile and pharmaceutical manufacturers could provide notice of dangers, stipulation is likely to fail in the first place.
42. Thus, stipulated damages are often struck as penalties where there is no opportunism, perhaps because the clause makes no attempt to anticipate actual damages, and also where there is objectionable behavior. See Phillips v. Phillips, 820 S.W.2d 785 (Tex. 1991) (holding serious breach, of fiduciary duty as breach of contract, but finding stipulated damages excessive compared to actual losses).
43. At the same time, stipulated damages are often accepted even where there is opportunism. See, e.g., N. Ill. Gas Co. v. Energy Coop., 461 N.E.2d 1049 (Ill. App. Ct. 1984) (holding that a petroleum ether supplier could collect no more than the stipulated damages after its gas company customer opportunistically terminated the contract).
44. Compare Farmers Union Grain Terminal Ass'n v. Nelson, 223 N.W.2d 494 (N.D. 1974) (holding that the breaching party is permitted to invoke the stipulated-damages clause as damage limitation),
45. with Carolinas Cotton Growers Ass'n v. Arnette, 371 F. Supp. 65 (D.S.C. 1974) (holding that the breaching party is not permitted to limit its liability to the stipulated-damages clause under similar circumstances);
46. compare also Margaret H. Wayne Trust v. Lipsky, 846 P.2d 904 (Idaho 1993) (permitting breachee to seek damages in excess of the stipulated amount),
47. with J. D. Pavlak, Ltd. v. William Davies Co., 351 N.E.2d 243 (Ill. App. Ct. 1976) (limiting breachee's damages to the stipulated amount).
48. Arrowhead School District No. 75, Park County v. Klyap, 79 P.3d 250 (Mont. 2003)
49. is an especially convenient case, as there is opportunity for joint mitigation, and enforcement against the breaching party. The contract stipulated damages equal to twenty percent of a teacher's annual compensation. The breaching party resigned just two weeks before the start of the academic year. A replacement teacher was found at a slightly lower salary, but with some effort and of quality not easily measured.
50. Thus, a repair-or-replace remedy for a defective product is normally upheld. See, e.g., Posttape Assocs, v. Eastman Kodak Co., 537 F.2d 751 (3d Cir. 1976).
51. But often so are earnest money agreements in real estate transactions, customized as they may be. See, e.g., United States v. Ponnapula, 246 F.3d 576, 580 (6th Cir. 2001).
52. But see Weber v. Rivera, 841 P.2d 534 (Mont. 1992) (refusing to enforce the clause in a real-estate sales form contract requiring the defaulting party to pay ten percent of purchase price).
53. There is the question of why it is so rare to see parties to this kind of contract agree upon stipulated damages. We do see some expensive restaurants asking for credit card information when taking reservations, and then imposing a stipulated fee for the patron's failure to materialize. Even if the taxi company stipulates X dollars for R's failure to wait, R may breach either because the alternative ride is free or because R fears missing a flight. And if Y dollars is stipulated for Ts failure to pick, up R as promised, T will still breach if another customer, S, pays a sufficiently higher price- though we have no reason to think that S values the ride more than R, whose fare was likely determined by a fixed schedule. But bargaining can encourage earlier transmittal of information. It might pay for R to stipulate that "I will pay you fifty dollars if I am a no-show, but only thirty dollars if I give more than one-hour notice." Similarly, we do find restaurants excusing the penalty with enough notice. But it is also possible that we do not often find more detailed stipulation because such stipulation, might be thought to encourage breach, as it offers a price for breach. See Uri Gneezy & Aldo Rustichini, A Fine Is a Price, 29 J. LEGAL STUD. 1 (2000) (finding that charges, or fines, at least within limits, increased rather than decreased late pickups at daycare centers). Still, at the right price, breach ought to be welcome. Some restaurants and airlines do seem comfortable with noshows, once fees have been included.