Lake River Corp v. Carborundum Co.

Case brief: template

Case name:	Lake River Corp v. Carborundum Co.
Court:	UNITED STATES COURT OF APPEALS FOR THE SEVENTH CIRCUIT
Citation; Date:	769 F.2d 1284; 1985

PROCEDURAL HISTORY
Trial court:		Appeal court (for appeal cases only):
Plaintiff:	Lake River - bagger	Appellant:
Defendant:	Carborundum - supplier	Respondent:

Facts of the case:
Carborundum manufactures "Ferro Carbo," an abrasive powder used in making steel. To serve its midwestern customers better, Carborundum made a contract with Lake River by which the latter agreed to provide distribution services in its warehouse in Illinois. Lake River would receive Ferro Carbo in bulk from Carborundum, "bag" it, and ship the bagged product to Carborundum's customers. The Ferro Carbo would remain Carborundum's property until delivered to the customers. Carborundum insisted that Lake River install a new bagging system to handle the contract. In order to be sure of being able to recover the cost of the new system ($89,000) and make a profit of 20 percent of the contract price, Lake River insisted on the following minimum-quantity guarantee: In consideration of the special equipment [i.e., the new bagging system] to be acquired and furnished by LAKE-RIVER for handling the product, CARBORUNDUM shall, during the initial three-year term of this Agreement, ship to LAKE-RIVER for bagging a minimum quantity of [22,500 tons]. If, at the end of the three-year term, this minimum quantity shall not have been shipped, LAKE-RIVER shall invoice CARBORUNDUM at the then prevailing rates for the difference between the quantity bagged and the minimum guaranteed. If Carborundum had shipped the full minimum quantity that it guaranteed, it would have owed Lake River roughly $533,000 under the contract. After the contract was signed in 1979, the demand for domestic steel, and with it the demand for Ferro Carbo, plummeted, and Carborundum failed to ship the guaranteed amount. When the contract expired late in 1982, Carborundum had shipped only 12,000 of the 22,500 tons it had guaranteed. Lake River had bagged the 12,000 tons and had billed Carborundum for this bagging, and Carborundum had paid, but by virtue of the formula in the minimum-guarantee clause Carborundum still owed Lake River $241,000 -- the contract price of $533,000 if the full amount of Ferro Carbo had been shipped, minus what Carborundum had paid for the bagging of the quantity it had shipped. When Lake River demanded payment of this amount, Carborundum refused, on the ground that the formula imposed a penalty.

Remedy sought:	Lake River brought this suit for $241,000, which it claims as liquidated damages. Carborundum counterclaimed for the value of the bagged Ferro Carbo when Lake River impounded it and the additional cost of serving the customers affected by the impounding. The theory of the counterclaim is that the impounding was a conversion, and not as Lake River contends the assertion of a lien. The district judge, after a bench trial, gave judgment for both parties. Carborundum ended up roughly $42,000 to the good: $269,000 + $31,000-$24100-$17,000, the last figure representing prejudgment interest on Lake River's damages. (We have rounded off all dollar figures to the nearest thousand.) Both parties have appealed.

Court opinion (including key issues and arguments):
This diversity suit between Lake River Corporation and Carborundum Company requires us to consider questions of Illinois commercial law, and in particular to explore the fuzzy line between penalty clauses and liquidated-damages clauses. The hardest issue in the case is whether the formula in the minimum-guarantee clause imposes a penalty for breach of contract or is merely an effort to liquidate damages. Deep as the hostility to penalty clauses runs in the common law, see Loyd, Penalties and Forfeitures, 29 Harv. L. Rev. 117 (1915), we still might be inclined to question, if we thought ourselves free to do so, whether a modern court should refuse to enforce a penalty clause where the signator is a substantial corporation, well able to avoid improvident commitments. Penalty clauses provide an earnest of performance. The clause here enhanced Carborundum's credibility in promising to ship the minimum amount guaranteed by showing that it was willing to pay the full contract price even if it failed to ship anything. On the other side it can be pointed out that by raising the cost of a breach of contract to the contract breaker, a penalty clause increases the risk to his other creditors; increases (what is the same thing and more, because bankruptcy imposes "deadweight" social costs) the risk of bankruptcy; and could amplify the business cycle by increasing the number of bankruptcies in bad times, which is when contracts are most likely to be broken. But since little effort is made to prevent businessmen from assuming risks, these reasons are no better than makeweights. A better argument is that a penalty clause may discourage efficient as well as inefficient breaches of contract. Suppose a breach would cost the promisee $12,000 in actual damages but would yield the promisor $20,000 in additional profits. Then there would be a net social gain from breach. After being fully compensated for his loss the promisor would be no worse off than if the contract had been performed, while the promisor would be better off by $8,000. But now suppose the contract contains a penalty clause under which the promisor if he breaks his promise must pay the promisee $25,000. The promisor will be discouraged from breaking the contract, since $25,000, the penalty, is greater than $20,000, the profits of the breach; and a transaction that would have increased value will be forgone. On this view, since compensatory damages should be sufficient to deter inefficient breaches (that is, breaches that cost the victim more than the gain to the contract breaker), penal damages could have no effect other than to deter some efficient breaches. But this overlooks the earlier point that the willingness to agree to a penalty clause is a way of making the promisor and his promise credible and may therefore be essential to inducing some value-maximizing contracts to be made. It also overlooks the more important point that the parties (always assuming they are fully competent) will, in deciding whether to include a penalty clause in their contract, weigh the gains against the costs -- costs that include the possibility of discouraging an efficient breach somewhere down the road -- and will include the clause only if the benefits exceed those costs as well as all other costs. On this view the refusal to enforce penalty clauses is (at best) paternalistic.... The responsibility for making innovations in the common law of Illinois rests with the courts of Illinois, and not with the federal courts in Illinois. Mindful that Illinois courts resolve doubtful cases in favor of classification as a penalty, we conclude that the damage formula in this case is a penalty and not a liquidation of damages, because it is designed always to assure Lake River more than its actual damages. The formula -- full contract price minus the amount already invoiced to Carborundum -- is invariant to the gravity of the breach. When a contract specifies a single sum in damages for any and all breaches even though it is apparent that all are not of the same gravity, the specification is not a reasonable effort to estimate damages; and when in addition the fixed sum greatly exceeds the actual damages likely to be inflicted by a minor breach, its character as a penalty becomes unmistakable. [follows with many illustrations of cost/profit calculations--interesting for Econ250] at whatever point in the life of the contract a breach occurs, the damage formula gives Lake River more than its lost profits from the breach -- dramatically more if the breach occurs at the beginning of the contract; tapering off at the end, it is true. Still, over the interval between the beginning of Lake River's performance and nearly the end, the clause could be expected to generate profits ranging from 400 percent of the expected contract profits to 130 percent of those profits. And this is on the assumption that the bagging system has no value apart from the contract.

Disposition of case:
AFFIRMED IN PART, REVERSED IN PART, AND REMANDED

ECONOMIC ANALYSIS OF THE CASE

Efficiency/incentive issues discussed in the court opinion:

Other efficiency/incentive issues relevant to the case:

Assessment of the economic consequences of the court decision:

     1. The Hadley v. Baxendale opinion has had universal acceptance in Anglo-American law as staling an appropriate rule of limitation on damages that would otherwise be recoverable under an unrestricted "expectation" rule. Does the decision itself appear to be sustainable on the facts of the Hadley case? In Victoria Laundry (Windsor) Ltd. v. Newman Industries. Ltd., [1949] 2 K.B. 528, 537 (C.A.), a later English court expressed the opinion that the headnote to Hadley is "definitely misleading in so far as it says that the defendants' clerk, who attended at the office, was told that the mill was stopped and that the shaft must be delivered immediately." If the court in Hadley had actually regarded that as established, it was suggested, then it is "reasonably plain" from Baron Alderson's opinion in Hadley that it would have decided that case "the other way round."
    On the other hand, it has been suggested that the opinion in Hadley can be viewed as consistent with the facts as stated in the headnote if one assumes that the clerk was not told either that the stoppage of the mill was solely due to the shaft's being broken or that no other shaft was available in the meantime. McCormick, The Contemplation Rule as a Limitation upon Damages for Breach of Contract, 19 Minn. L. Rev. 497, 500-501 (1935).
    Professor Richard Danzig concludes that there is evidence both ways on the question of whether the Hadleys indeed "served notice on the . . . clerk of their extreme dependence on the shaft," but suggests that in any event the "rudimentary law of agency" as it then existed might have required notice to be served on Baxendale himself, or at least on some agent more exalted than a mere receiving clerk. Danzig, Hadley v. Baxendale, A Study in the Industrialization of the Law, 4J. Leg. Stud. 249, 262-263 (1975). Professor Danzig's article (subReadings for Thursday, December 13, 2001 Page 4 stantially incorporated also in his book The Capability Problem in Contract Law (1978)) is an unusually interesting exploration of the context in which the Hadley case was decided. Besides the now conventional notion that the Hadley decision was more or less consciously an attempt to protect infant industries in the early stages of the industrial revolution. Professor Danzig sees a number of other factors reflected in that decision: tensions between Parliament and the courts, between different courts, and between judge and jury; differences over the proper extent of liability of common carriers, and about the way in which their activities should be regulated; and the still "rudimentary" state in 1854 of both commercial and agency law.
    2. The two types of damages described by the court in Hadley are frequently characterized as "general" and "special" damages. Professor John Murray has offered the following definitions of those terms: The distinction between general and special damages is often stated as follows: the former arise naturally from the breach and are implied or presumed by the law. The latter do not arise naturally; they are not within the common experience of mankind as arising in the particular situation and, therefore, they are not implied or presumed by the law. Thus, the terms general and special may be used synonymously with the terms natural and unnatural, usual and unusual. Murray goes on to point out that although all injury resulting from breach is literally "consequential," that term is ordinarily used only to refer to "special," or "unusual," damage. J. Murray, Contracts §225 n.48 (1974). Copyright 1974 by The Michie Co.
    3. Although the rule of Hadley v. Baxendale has been viewed traditionally as a rule limiting damages for breach of contract, it has also been applied to tort cases. See, e.g., Evra Corp. v. Swiss Bank Corp., 673 F.2d 951 (7th Cir. 1982) (Posner,J.); see also Kerr S.S. Co. v. Radio Corp. of America, 245 N.Y. 284, 157 N.E. 140 (1927) (Cardozo, C.J.). In the Evra case, the Court of Appeals invoked Hadley as authority for its ruling that the defendant bank was not liable for profits lost as a result of defendant's failure to act with due care in transmitting funds as directed by plaintiff; the delay in transmission caused the plaintiff to lose its right to an advantageous ship-charter contract. (The action was in tort because there was no direct privity between plaintiff and the defendant, which acted on instructions forwarded to it by intermediary banks.) Although justified by the court in terms of the Hadley requirement of foreseeability, the Evra decision has also been analyzed as an application of Judge Posner's economic theories, in effect transmuting the Hadley rule of foreseeability into a rule imposing liability on the party best able to avoid the injurious consequences of breach at the lowest cost, and thus reaching the "efficient" result. Note, An Economic Approach to Hadley v. Baxendale, 62 Neb. L. Rev. 157 (1983). A case with facts similar to Evra, and reaching the same result, is Central Coordinates, Inc. v. Morgan Guaranty Trust Co., 494 N.Y.S.2d 602 (Sup. Ct. 1985) (loss claimed to have resulted from bank's alleged delay in transmitting wire order for transfer of funds; no recovery on contract, negligence, or strict liability).