Your Gain Is My Award: a Potential Disgorgement Remedy for Colorado Contract Claims
| Publication year | 2014 |
| Pages | 45 |
| Citation | Vol. 43 No. 11 Pg. 45 |
Articles
The Civil Litigator
Your Gain is My Award: A Potential Disgorgement Remedy for Colorado Contract Claims
By Matthew Spohn
The Civil Litigator articles address issues of importance and interest to litigators and trial lawyers practicing in Colorado courts. The Civil Litigator is published six times a year.
Coordinating Editor
Timothy Reynolds, Boulder, of Bryan Cave HRO—(303) 417-8510, timothy.reynolds@bryancave.com
The Colorado Court of Appeals' recent decision in Watson v. Cal-Three, LLC suggests that the party breaching a contract may be required to disgorge its own profits earned from the breach. This article analyzes the context of that decision and its potential effects on Colorado contract law.
At first read, the Colorado Supreme Court's decision in Earthlnfo, Inc. v. Hydrosphere Resource Consultants, Inc.[1] may seem unremarkable: On rescission of a contract, the parties must make restitution to each other. However, a recent interpretation of this case by the Colorado Court of Appeals in Watson v. Cal-Three, LLC[2] raises the question of whether Earthlnfo established a much more novel proposition: On a breach of contract, the breaching party may be required to disgorge its own profits earned from the breach.
Though these cases may provide breach-of-contract plaintiffs an entirely new remedy, they appear to be little used, perhaps because they are not fully understood. This article explores the legal framework in which the Earthlnfo and Watson decisions arose, and the issues they may raise for litigants in Colorado courts.
Traditional Views of Contract Damages and Restitution
To understand how groundbreaking the Earthlnfo and Watson decisions may be with respect to contract damages and restitutionary recovery, one must first understand the background from which they emerged. It is fundamental contract law that damages for breach are measured by the expectation interest—"the amount required to put the plaintiff in the same position as if the breach had not occurred," in the words of the Colorado jury instruction.[3] This amounts to an inquiry into what the plaintiff would have gained had the contract been honored.[4]
Restitution is essentially the opposite of expectation damages. Instead of looking to the benefits that would have been realized if the parties had performed, it looks to the benefits already gained by the party at fault. Broadly stated, "[restitution is a return or restoration of what the defendant has gained in a transaction."[5] Traditionally, restitution is not a measure of contract damages, but it a rises in several contract-related contexts.
First, restitution is the remedy for a claim of unjust enrichment. A claim for unjust enrichment arises only in the absence of a contract,[6] where the plaintiff establishes:
(1) that a benefit was conferred on the defendant by the plaintiff, (2) that the benefit was appreciated by the defendant, and (3) that the benefit was accepted by the defendant under such circumstances that it would be inequitable for it to be retained without payment of its value.[7]
The claim is sometimes described as a "quasi-contract" imposed to prevent injustice,[8] and the restitutionary remedy returns to the plaintiff the defendant's unjust gain.
Second, restitution is a remedy where a purported contract is void, voided, or unenforceable because it is illegal, violates the statute of frauds, or is the product of fraud or mistake. In those instances, the parties make restitution to each other to put themselves back in the positions they would have occupied if they had not attempted to contract with each other.[9]
Third, in a similar vein, restitution is a remedy when a contract is rescinded by one of the parties. It arises from the contract law principle that a "substantial breach," or a "breach which goes to the essence of the contract," allows the non-breaching party to rescind the contract.[10] On the rescission, the parties make restitution to each other.[11] This principle is well established in Colorado and usually arises in the context of construction contracts—if the builder's failure is so fundamental, the buyer may rescind the construction contract and get restitution of whatever he or she paid, less any value that the builder provided in its failed attempt to construct what was contracted for.[12]
The Earthlnfo Decision
At first blush, the Colorado Supreme Court's decision in Earthlnfo[13] appears to be an unremarkable application of the third category of traditional contract-related restitution on rescission. A software developer and its client dispute the terms of the software development contract, the developer rescinds the contract because of substantial breach, and the parties are ordered to make restitution to each other. Because the case draws on a different meaning of the term "restitution," however, it broke new ground in Colorado law.
The Facts: A Seemingly Ordinary Software Development Contract Dispute
Earthlnfo, Inc. was assigned its predecessor's contract with Hydrosphere Resource Consultants, Inc., whereby Hydrosphere would develop CD-ROM units and software to make government-collected hydrological and meteorological information available to the public.[14] Earthlnfo was to pay Hydrosphere fixed hourly development fees, as well as royalties on its net sales.[15] Hydrosphere performed but Earthlnfo ceased paying any royalties because Hydrosphere asserted that a new derivative product offered by Earthlnfo was subject to royalties under their agreement. Earthlnfo disagreed. On Earthlnfo's suspension of royalty payments, Hydrosphere rescinded their contract and sued for restitution.[16]
This factual posture may foster some confusion about the case's ultimate holding. Normally, a failure to pay (such as Earthlnfo's withholding of royalty payments) is not a ground for rescinding a contract; instead, the remedy is to sue for payment.[17] However, at trial, "both parties sought rescission of the Contracts and restitution as a remedy."[18] That move worked out poorly for Earthlnfo, but the choice is understandable, given the general rule that restitution is usually understood to mean the restoration of what each party previously possessed, at least in the context of contract-related restitution.[19] Earthlnfo may have calculated that rescission of its contract was to its advantage: it would be required to return the software and other materials developed by Hydrosphere, but then it would get its money back, likely with some deduction for the value that was provided and used. Had that happened, the case would be fairly unremarkable.
Instead, the trial court ordered a much more far-reaching restitution on the parties' mutual rescission. In addition to the restitution Earthlnfo likely expected (return of the materials developed by Hydrosphere accompanied by a return of the price paid for them), the court ordered that Earthlnfo pay to Hydrosphere the profits Earthlnfo had earned from using the materials Hydrosphere developed, totaling $265,204.91.[20] Earthlnfo promptly appealed, and its appeal was...
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