Various Problems with Liquidated Damages

I 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.

Professor 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.