Citation. 769 F.2d 1284 (7th Cir. 1985)
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Brief Fact Summary.
A manufacturer and distributor entered into an agreement, whereby the distributor was to distribute a product made by the manufacturer. The manufacturing party guaranteed that the distributor would ship a certain minimum amount of tons. A clause in the contract required the manufacturer to pay for the difference if the minimum amount of tons was not reached.
Synopsis of Rule of Law.
"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."
The Plaintiff, Lake River. Corp (the "Plaintiff"), contracted with the Defendant, Carborundum Co. (the "Defendant"), to distribute "Ferro Carbo" an abrasive powder used in making steel manufactured by the Defendant. The Plaintiff was required to bag and ship the powder. The Defendant guaranteed the Plaintiff that it would ship a minimum of 22,500 tons of powder, and if that minimum was not met, the Defendant would still be obligated to pay "the going rate for bagging and shipping of the unshipped quantity." Demand for the powder diminished, and the Defendant could not ship the 22,500 tons and based on the agreement would have had to pay the Plaintiff $241,000.
"[W]hether the formula in the minimum-guarantee clause imposes a penalty for breach of contract or is merely an effort to liquidate damages"?
The court recognizes that there was a hostility at common law for penalty clauses, but then questions the wisdom of that especially when it is a corporation that is bound by the penalty clause. The court observed this clause "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 hand, this type of clause increases the risk to other creditors, due to the risk of bankruptcy. Additionally, penalty clauses "may discourage efficient as well as inefficient breaches of contract."
• The court also recognizes that also overlooked is "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."
• Regardless of this judge's views, however, he is hesitant to impose the federal courts view of contract law where Illinois state law applies and under Illinois law "a liquidation of damages must be a reasonable estimate at the time of contracting of the likely damages from breach, and the need for estimation at that time must be shown by reference to the likely difficulty of measuring the actual damages from a breach of contract after the breach occurs." Consequently, "[i]f damages would be easy to determine then, or if the estimate greatly exceeds a reasonable upper estimate of what the damages are likely to be, it is a penalty."
This case offers an interesting discussion about determining whether a given clause is a penalty clause or a liquidated damage clause.