Lake River Corp. v. Carborundum Co.
769 F.2d 1284 (1985)
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Rule of Law:
A liquidated damages clause is an unenforceable penalty if it specifies damages that are grossly disproportionate to a reasonable estimate of actual damages, particularly when the formula fails to account for the costs the non-breaching party saved by not having to fully perform the contract.
Facts:
- Carborundum Company manufactured an abrasive powder called 'Ferro Carbo' and contracted with Lake River Corporation for bagging and distribution services.
- The three-year contract required Lake River to purchase and install a new, specialized bagging system for $89,000.
- To ensure Lake River could recover its investment, the contract included a minimum-quantity guarantee, obligating Carborundum to ship at least 22,500 tons of Ferro Carbo for bagging.
- The guarantee clause stipulated that if Carborundum failed to ship the minimum quantity, it would be invoiced for the shortfall at the prevailing rate, effectively paying the full contract price as if the product had been bagged and shipped.
- A downturn in the steel industry caused demand for Ferro Carbo to plummet.
- By the end of the contract term, Carborundum had shipped only 12,000 of the guaranteed 22,500 tons.
- Lake River invoiced Carborundum for $241,000, representing the full payment due for the 10,500-ton shortfall.
- When Carborundum refused to pay, arguing the clause was a penalty, Lake River withheld 500 tons of Carborundum's bagged product that was in its warehouse.
Procedural Posture:
- Lake River Corporation sued Carborundum Company in federal district court, seeking to recover $241,000 under the contract's minimum-guarantee clause.
- Carborundum filed a counterclaim, alleging that Lake River's retention of its property was a conversion and seeking the value of the goods plus additional costs.
- After a bench trial, the district court entered judgment for both parties, with a net award in favor of Carborundum.
- Both Lake River (as appellant-cross-appellee) and Carborundum (as appellee-cross-appellant) appealed the district court's judgment to the U.S. Court of Appeals for the Seventh Circuit.
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Issue:
Does a contract's minimum-quantity guarantee formula, which requires a breaching party to pay the full contract price for services not performed, constitute an unenforceable penalty clause rather than a valid liquidated damages clause under Illinois law?
Opinions:
Majority - Posner, Circuit Judge.
Yes. The minimum-quantity guarantee formula is an unenforceable penalty clause because it is designed to always provide Lake River with compensation in excess of its actual damages. Under Illinois law, a valid liquidated damages provision must be a reasonable estimate of the potential damages that would be difficult to calculate at the time of contracting. The formula here fails this test because it is invariant to the gravity of the breach and does not account for the significant variable costs Lake River would save by not having to perform the bagging services. For example, if the breach occurred on the first day, Lake River would have incurred minimal costs but would still receive the full contract price, resulting in a massive windfall far exceeding any expected profit. Because the formula is not a reasonable attempt to estimate actual loss and instead guarantees a payment grossly disproportionate to any probable harm, it is an invalid penalty.
Analysis:
This case provides a classic law and economics analysis of the distinction between liquidated damages and penalty clauses. Judge Posner, while acknowledging the economic arguments for enforcing penalty clauses between sophisticated commercial parties, faithfully applies established Illinois law. The decision solidifies the principle that a damages formula is penal if it fails to deduct the promisee's saved costs from non-performance. This reasoning is highly influential and serves as a clear warning that 'take-or-pay' style clauses will be scrutinized for their relationship to actual damages, preventing non-breaching parties from receiving a windfall far greater than their lost profits.
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