Formal and Operative Rules in Overliquidation Per Se Cases

• Published date: 01 June 2004
• DOI: http://doi.org/10.1111/j.1744-1714.2004.04104003.x
• Author: Ann Morales Olazábal
• Date: 01 June 2004

Formal and Operative Rules in

Overliquidation Per Se Cases

Ann Morales Olaza

´

bal

n

It is unusual outside the natural sciences and certainly rare in the field of

legal scholarship to find an opportunity to design a controlled experiment

with replicant data points. This article considers such an anomaly in the

law, using as its laboratory judicial opinions addressing the enforcement

of agreed damage clauses when, fortuitously, the nonbreaching party in-

curred no damageFa phenomenon I will call overliquidation per se.

This subset of decisions presents something of a microcosm of the existing

confused and contradictory jurisprudence on liquidated damages clauses

in general. But functional analysis of this curious group of subject cases

produces some guidance in the form of a set of working or de facto rules

that appear to be in effect in modern courts faced with overliquidation

per se situations. In turn, analysis of the operative rules themselves

permits formulation of a new formal rule for the overliquidation per se

setting.

As more fully discussed below, in disputes involving overliquidation

per se cases, the article recommends that courts adopt an objective,

prospective-only view of damage stipulations, eschewing the practice of

using actual damages as an indicator of whether the parties’ pre-estimate

was reasonable. Further, the article suggests that the absence of

damages or no compensable loss should provide a second-step equitable

inquiry in the atypical context presented by overliquidation per se cases.

503

American Business Law Journal

Volume 41, Issue 4, 503–558, Summer 2004

n

Assistant Professor of Business Law, University of Miami School of Business Administration;

Member, Arizona Bar; J.D., 1987, Universityof Notre Dame Law School; M.B.A., 1997, Uni-

versity of Miami School of Business Administration; B.A., 1984, Texas Christian University.

I am grateful to Don Weisner for introducing the topicof penal clauses to me nearly ten years

ago, and to the University of Miami School of Business Administration’s 2003 Faculty Devel-

opment Grant, both of which enabled this work.

I. INTRODUCTION

In her work entitled Formal and Operative Rules Under Common Law and

Code,

1

noted scholar Elizabeth Warren analyzed so-called ‘‘underliquidated

damages’’

2

cases, advancing the premise that the classical rules of contract

law announced in the judicial opinions in that area are only ‘‘labels that the

courts applied after they had decided the cases on some other grounds.’’

3

Professor Warren found that mere application of the formal rulesFboth

under the common law of contracts and the CodeFdoes not explain

the outcomes of the cases.

4

According to Warren this is because the

1

Elizabeth Warren, Formal and Operative Rules Under Common Law and Code, 30 UCLA L. REV.

898 (1983).

2

Warren describes underliquidation as ‘‘the atypical liquidated damages case, where the ag-

grieved party discovers after a contract breach that the damages he can prove at law far ex-

ceed those provided in the liquidated damages clause.’’ Accordingly, in such a case the

purported liquidated damage clauseFif enforcedFserves as a limitation of liability, or as

Warren describes it, ‘‘the breaching party’s shield from provable damages.’’ Id. at 901; see also

William F. Fritz,‘‘Underliquidated’’ Damages as Limitation of Liability,33T

EX.L.REV. 196 (1954).

‘‘Liquidated damages,’’ as used in this article, should be distinguished from limitations on

damages. See U.C.C. § 2-719 (limitations of damages in sales contracts). Clauses calling for

limitations may specify a dollar cap or may limit the remedy to the provision of a specific

service (i.e., repair/replacement), or such clauses may simply exclude certain categories of

damages (e.g., consequential or incidental damages). J. WHITE &R.SUMMERS,HANDBOOK OF

THE LAW UNDER THE UNIFORM COMMERCIAL CODE 376–96 (1972). The primary distinction be-

tween damage liquidations and limitations is that the stipulated damages clause fixes the

amount of recovery,while the limitation on damages provides a ceiling or maximum recovery,

depending upon the losses actually proven. Damage limitations are usually not unenforceable

penalties, because they generally do not have an in terrorem effect. See,e.g.,22A

M.JUR.2D

Damages § 685 (1988).

3

See Warren, supra note 1, at 909. In the area of liquidated damages, Professors Calamari and

Perillo have also noted that courts ‘‘ritualistically’’ state the formal rules of contract law and

then proceed to disregard some of aspects of the stated rule almostentirely. JOHN D. CALAMARI

&JOSEPH M. PERILLO,THE LAW of CONTRACTS 367 (1970).

4

Warren, supra note 1, at 909. In developing her hypothesis regarding formal and operative

rules, Warren tips her hat to Professor Gilmore, who more than thirty years ago discussed the

disparity between stated law and effective rules in the areas, inter alia, of mutuality of obli-

gation, absolute liability, andrecovery of consequential damages for breach of contract. Id.at

905 n.38 (citing GRANT GILMORE,THE DEATH OF CONTRACT 77–85 (1974)). Professor DiMatteo

investigated the application of formal contract rules versus both overt and covert judicial in-

quiry into the fairness of the exchange (as opposed to the remedy granted) in the areas of the

law of satisfaction clauses, covenants not to compete, and comfort instruments. See Larry A.

DiMatteo, The Norms of Contract: The FairnessInquiry and the ‘‘Law of Satisfaction’’FA Nonunified

Theory,24H

OFSTRA L. REV. 349 (1995).

504 Vol. 41 / American Business Law Journal

penalty doctrine,

5

the legal test that is typically applied to underliquidation

cases, is a test with no substantive content. In this regard, Warren wryly

notes:

A test isolates some factors important to deciding cases and offers a standard of

measurement. A test has some predictive value. A test distinguishes groups of

cases from other groups of cases with the test factor as the dominant variable.

Perhaps the penalty/disproportion test could do these things. As it has been

used in underliquidated damages cases, however, it does none of them.

6

Warren developed a set of ‘‘operative rules’’ or overlapping ques-

tions, the answer(s) to which invariably account for the published results.

7

Warren based her inquiry on the notion that any attempt to make sense of

our muddled modern contract law must be grounded in the ‘‘actual

functioning of the system.’’

8

Ultimately, in addition to enabling her to draw

some general conclusions about our dual system of contract law and how it

changes over time, Professor Warren’s focused study of formal versus op-

erative rules permitted her to articulate and explain the de facto rules, or

functional test, for the determination of underliquidated damage cases.

9

I posit that while the underliquidation cases serve as an interesting

guinea pig for observation and demonstration of the formal-versus-

operative-rules dynamic, there is a much more compelling contract labo-

ratory in which to conduct this type of experiment. Consequently in

this article, I apply Warren’s methodology to ‘‘overliquidation per se’’

casesFliquidated damage suits in which the nonbreaching party

5

Warren, supra note 1, at 907.

6

Id. at 906–07.

7

Warren’s study enabled her to conclude as follows:

The cases reveal three recurring questions: (1) Did the parties intend the liquidated

damages clause to cover the type of breach complained of in the case? (2) Did the parties

include the liquidated damages clause as a ceiling or a floor on damages? (3) Is enforce-

ment of the liquidated damages clause unconscionable? These questions overlap, but, in

nearly every case, resolving one question explains the case’s outcome.

Id.at 910.

8

Id. at 898.

9

Calling the existence of formal rules and operative rules in our system of contract law a ‘‘dual

system,’’ Warren concludes that the ‘‘most significant consequence of a dual system is that it

interrupts the testing and refining of rules of law’’ by, inter alia, ‘‘discourag[ing] analogical

reasoning.’’ Id. at 919–20.

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