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Liquidated Damages

 
Lawyers often insert liquidated damages clauses into contracts, intending to specify the amount of damages that one party will receive if the other party breaches the agreement. These clauses can be efficient mechanisms for dispute resolution, eliminating the need to prove damages and, thereby, streamlining litigation (if not avoiding it altogether). However, California law places several restrictions on the enforceability of such provisions, with different requirements under different circumstances.

General Rules

Whether or not a liquidated damages clause is enforceable is a question of law. (Harbor Island Holdings v. Kim, 107 Cal. App. 4th 790, 794 (2003).) The question likely will turn on the facts of the case but also on several governing statutes that apply to specific types of transactions. But first a bit of background.

The California Civil Code mandates that a liquidated damages clause is valid unless a party establishes that it was “unreasonable under the circumstances existing at the time the contract was made.” (Cal. Civ. Code § 1671(b).) However, this rule does not apply in cases in which another applicable statute prescribes a different standard. (See Cal. Civ. Code § 1671(a).)

A key exception is when the contract concerns the purchase or rental of personal property; a service used primarily for personal, family, or household purposes; or a residential lease. In those cases, a liquidated damages clause is void except when “from the nature of the case, it would be impracticable or extremely difficult to fix the actual damage.” (See Cal. Civ. Code § 1671(c) and (d).)

The amount of liquidated damages stated in a contract also must represent a reasonable endeavor to estimate fair compensation for the loss sustained. If the stated amount is “designed to substantially exceed the damages suffered, and its primary purpose is to serve as a threat to compel compliance through the imposition of charges bearing little or no relationship to the amount of actual loss,” then the purported liquidated damages clause will be an invalid attempt to impose a penalty. (Utility Consumers’ Action Network, Inc. v. AT&T Broadband, 135 Cal. App. 4th 1023, 1029 (2006).)

In the Utility Consumers case, the court upheld the late fee in Internet cable service contracts (in which the amount was conceded to be reasonable), ruling that a company does not have to negotiate the late fee individually with each customer; the fee may be unilaterally set by one of the parties to a contract. (Utility Consumers, 135 Cal. App. 4th at 1025.)

In another case, the court of appeal struck down early-termination fees in consumer cell phone contracts, holding that the cellular telephone carrier (in this case, Sprint), failed the “reasonable endeavor” test because it did not undertake any effort to approximate the damages that would flow from a consumer’s breach of contract. (Cellphone Termination Fee Cases, 193 Cal. App. 4th 298 (2011).)

Key Factors

Some cases are more instructive than others. In one instance, a federal district court upheld a liquidated damages clause that forced a buyer to forfeit a deposit for the purchase of a vintage car. The buyer had failed to pay the balance due, and the dealer sold the car to someone else for more money. The buyer sued for return of his deposit, but the court, after analyzing several factors, upheld the liquidated damages clause. The court quoted from the Law Revision Commission Comments to Civil Code section 1671 (“the amount of damages actually suffered has no bearing on the validity of the liquidated damages provision”) and noted that the amount in question was a standard figure in vintage-car sales contracts – a key fact that supported a finding of reasonableness.

The court also cited other factors, such as “the relative equality of the bargaining power of the parties” and whether lawyers represented the parties when the contract was made. A crucial fact was that the buyer was sophisticated in the practices of buying and selling high-end vintage cars. In the overall context, the court observed that the amount of liquidated damages reasonably reflected the defendant’s risk, as well as the damages that could have been anticipated at the time of contracting. (See Edwards v. Symbolic International, Inc. (2009 WL 1178662 (S.D. Cal.).)

However, in a different situation – involving real estate – the sophistication of the parties proved to be irrelevant. In Kuish v. Smith (181 Cal. App. 4th 1419 (2010)), a California appellate court held unenforceable a nonrefundable-deposit provision in a $14 million residential purchase contract. Both parties were deemed sophisticated, and the buyer backed out while the seller proceeded to sell the property for more money to a third party. But the result was far different from the vintage-car case.

In fact, the nonrefundable-deposit provision did not even appear to comply with Civil Code section 1675, which covers liquidated damages clauses in residential real estate purchase contracts. Interestingly, the Kuish court did not base its decision on section 1675. Rather, it noted that in a rising real estate market, where the property resells for more than the original purchase price, the seller has not sustained a loss. In that scenario, a nonrefundable deposit would constitute an unenforceable penalty. (181 Cal. App. 4th at 1427.)

To further demonstrate the point that context matters, another court held that a late charge of 10 percent in a promissory note was unenforceable when tacked onto a large balloon payment due upon the note’s maturity. Although the regular installment payments (interest only) were $6,146.66 per month, the balloon was $776,146.66.

The 10 percent fee produced markedly different results, depending on the size of the missed payment. “A late charge provision covering administrative expenses that amounts to $614.67 for one late payment and $77,614.67 for another,” said the court, “is not a reasonable attempt to estimate actual … costs incurred, whether or not it is customary in the industry.” (Poseidon Development, Inc. v. Woodland Lane Estates, LLC, 152 Cal. App. 4th 1106, 1116 (2007).)

Excess Damages

Some clauses provide for “per day” or “per month” damages. In such cases parties need to be careful, lest a court conclude that a clause that runs on forever is unreasonable. That is exactly what happened when the court struck down a liquidated damages provision in a lease that provided a late fee of $2,500 per day to the tenant if the landlord could not deliver completed premises by a specified deadline. Because the delay damages could continue in perpetuity, they imposed potentially unlimited damages, and therefore bore no rational relationship to the actual harm expected to flow from the breach. (See Dollar Tree Stores Inc. v. Toyama Partners LLC, 875 F. Supp. 2d 1058, 1073 (N.D. Cal. 2012).)

As many construction contracts contain “per day” provisions for delay damages, parties should carefully consider inserting a reasonable cap on delay damages in order to protect the concept from attack. (See also El Centro Mall, LLC v. Payless Shoesource, Inc., 174 Cal. App. 4th 58 (2009) (court of appeal upheld a 10 cents per day per-square-foot liquidated damages provision against a tenant for breaching its covenant to stay open for business).)

No Penalties

Closely related to the above line of reasoning is a code section that allows a party to be relieved from a “forfeiture” if full payment is made to the other party, provided there has been no “grossly negligent, willful, or fraudulent breach of duty.” (See Cal. Civ. Code § 3275.) In essence, this rule means that a liquidated damages clause cannot amount to a penalty.

A case in point is Ridgley v. Topa Thrift (17 Cal. 4th 970, 979 (1998)). In that instance, the California Supreme Court held that a prepayment provision in a loan document constituted an unenforceable penalty because it applied only when the borrower was late with an interest payment; the liquidated damages were to be imposed in addition to a stipulated 10 percent late-payment fee. The court analyzed the interplay between Civil Code sections 3275 and 1671, noting that for a liquidated damages provision to be enforceable, it must bear a “reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.” The court then went further, commenting that “[t]he characteristic feature of a penalty is its lack of proportional relation to the damages which may actually flow from the failure to perform under a contract.” (Ridgley, 17 Cal. 4th at 977.) In the Ridgley case, the prepayment fee was approximately $113,000, which was equal to six months of interest. The court noted that the lender offered no plausible argument that the prepayment fee resulted from a reasonable endeavor to estimate fair compensation for any loss for late payment. (Ridgley, 17 Cal. 4th at 979.)

Conversely, a bankruptcy court upheld a $364,578 stipulated judgment against parties who failed to withdraw a bankruptcy claim by a deadline specified in a settlement agreement. (In re VEC Farms, LLC, 395 B.R. 674 (N.D. Cal. 2008).) The court declined to follow Sybron Corp. v. Clark Hosp. Supply Corp. (76 Cal. App. 3d 896 (1978)), which held that a settlement agreement calling for installment payments totaling $72,000 and allowing entry of a stipulated judgment for $100,000 upon any default was an unenforceable penalty.

Residential Transactions

Special rules govern liquidated damages clauses in contracts for the purchase of real estate containing up to four residential units, where the buyer intends to occupy one of the units as his or her residence. (Cal. Civ. Code § 1675(a).) To be valid, the liquidated damages provision must be separately signed or initialed and in at least 10-point bold type or 8-point bold and red type. (See Cal. Civ. Code § 1677.)

In general, subject to these prerequisites, as long as the liquidated damages provision does not exceed 3 percent of the purchase price the provision “is valid unless the buyer establishes that the amount is unreasonable as liquidated damages.” (Cal. Civ. Code § 1675(c).) Conversely, if the amount paid exceeds 3 percent of the purchase price, the provision is invalid unless the party seeking to uphold it establishes that the amount is reasonable. (Cal. Civ. Code § 1675(d).)

Reasonableness is determined by taking into account the circumstances existing at the time the contract was made and the price and other terms and circumstances of any subsequent sale made within six months of the buyer’s default. (Cal. Civ. Code § 1675(e).) Note, however, that for the initial sale of newly constructed condominium units within a project of ten or more residential units, a special rule applies that allows the seller to retain more than 3 percent under certain circumstances. (Cal. Civ. Code § 1675(f).)

These requirements have teeth. Indeed, one court held that when a minor delay in the deal triggered liquidated damages amounting to approximately 8.5 percent of the purchase price, the damages were unenforceable – even though the liquidated damages clause was contained in a court-approved settlement agreement that came into existence following specific performance litigation. (See Timney v. Lin, 106 Cal. App. 4th 1121, 1129 (2003).) Because the designated damages exceeded 3 percent of the purchase price, the liquidated damages clause was presumed invalid under section 1675(d). The fact that it was in a settlement agreement made no difference. Another case involved a buyer who failed to close escrow and sued to recover the deposit. The agreement limited liquidated damages to 3 percent of the purchase price and required any excess deposit to be returned to the buyer. A counteroffer provided the deposit would be released to the seller upon removal of contingencies as “nonrefundable option monies.” The court concluded that the parties intended to enter into a purchase agreement, not an option, and ordered the portion of the deposit exceeding 3 percent of the purchase price to be returned to the buyer. (Allen v. Smith, 94 Cal. App. 4th 1270, 1279 (2002).)

The lesson here is straightforward: In a case involving a residential sale, the parties should limit the total liquidated damages to no more than 3 percent of the purchase price in order to benefit from the statutory presumption of validity.

Commercial Real Estate

The rules are different in the commercial context. Pursuant to the code, a liquidated damages clause in a nonresidential real estate purchase contract is presumed valid if the provision is separately signed or initialed by each party and, if contained in a printed contract, it is set out in at least 10-point bold type or in contrasting red print in at least 8-point bold type. Even so, if the party seeking to invalidate the clause establishes that the provision was unreasonable under circumstances existing at the time the contract was made, a court can still strike it down. (See Cal. Civ. Code § 1676 (which references sections 1677 and 1671).)

In Hong v. Somerset Associates (161 Cal. App. 3d 111 (1984)), the court upheld a liquidated damage clause in an apartment building-purchase contract. The designated damages were $25,000 in a transaction that called for a purchase price of $1,325,000 (slightly less than 2 percent of the purchase price).

One should note that the statutes dealing with liquidated damages in real estate purchase contracts do not affect a party’s right to obtain specific performance. (See Cal. Civ. Code § 1680.)

Beware of Context

When drafting or analyzing a liquidated damages clause in a contract governed by California law, counsel should always remember that different rules apply, depending on the circumstances. However, keep in mind two fundamental guidelines in every case. First, a liquidated damages provision should be reasonable at the time it is drafted. Second, the greater the effort made to earnestly determine a fair measure of damages – as opposed to simply picking an arbitrary number – the better the chances the clause will pass judicial scrutiny.

Even though the rules that govern them are complex, liquidated damages clauses are useful. As one court observed: “liquidated damages do serve an important function. They remove the uncertainty factor from determining damages from a breach of contract and reduce litigation.” (Utility Consumers, 135 Cal. App. 4th at 1038.) Compliance with statutory mandates will help assure that these goals remain within reach.

 

Contracts and Juries

California law on interpreting disputed contracts is not what many lawyers think it is – and the same goes for deeds, wills, and other written instruments.

Who is vested with the power to say what a contract means? Is it a question of law for the trial judge? Or does a jury get to make the call?

Any attorney who thinks a bright-line rule will leap out of Witkin’s treatises to end the discussion is in for a surprise. Indeed, the real answer to these questions is “it depends,” because the factors governing who interprets a contract can prove vexing.

Such determinations are no esoteric exercise for a law school seminar; they have real-world consequences. The prospect of a jury interpreting a complex agreement is enough to make any transactional lawyer’s hands tremble. Advocates and clients also have reason for trepidation, especially in cases where emotional or equitable factors might overwhelm deliberations in the jury room. Fortunes may turn on a lay jury’s interpretation of a complex contract that transactional lawyers negotiated over the course of months. In City of Hope v. Genentech, Inc. (43 Cal. 4th 375 (2008)), for example, the jury returned a verdict of $300 million in compensatory damages. And when contract interpretation is a question of fact for the jury, appellate review typically is so deferential as to be virtually nonexistent.

Key Precedent

So what factors determine when a jury will decide what a contract means?

The seminal case is Parsons v. Bristol Development Co. (62 Cal. 2d 861 (1965)), in which the California Supreme Court established several black-letter rules. These have been reaffirmed many times, but often they are misunderstood by trial lawyers and judges.

– If there is no extrinsic evidence (that is, if the contract is to be interpreted strictly from the face of the instrument), interpretation is a question of law for the court.

– If such a decision is appealed, the appellate court reviews the contract interpretation issue de novo, with no deference to the trial court.

– The same rules apply if there is uncontested extrinsic evidence: Interpretation is a question of law, and it is reviewed de novo on appeal.

– In cases of undisputed extrinsic evidence, review is de novo even if there are disputes over the inferences that should be drawn from it.

– Contract interpretation becomes a question of fact for a jury to resolve when there are material conflicts in the extrinsic evidence – such as disputes over what was said during contract negotiations, what was done after contracting but before the dispute arose, or the relevant custom and practice in the industry. (See Parsons, 62 Cal. 2d at 865.)

The last of these rules has proved to be the real troublemaker. Indeed, litigators can count on a fierce pretrial fight over whether there are material extrinsic fact disputes that convert the contract interpretation into a jury question.

If the trial court correctly applies these rules, many – perhaps most – contract interpretation disputes will present questions of law that the trial judge decides and the appellate court redetermines de novo. This could mean that the contract’s meaning can be resolved on a motion for summary judgment; if not, it should be resolved by the trial court in time to instruct the jury as to the contract’s meaning.

Factual Disputes with Juries

 If material extrinsic fact disputes do make contract interpretation a question of fact, then things start to get complicated, especially if the case is to go before a jury. In many cases – City of Hope was one of them – a lay jury will be required to apply the very contract-interpretation principles that trial lawyers labor to master during their law school years. For this reason, the approved jury instructions include some general principles of contract interpretation. (See CACI Inst. 314320.) Just reading these instructions and thinking about what jurors in a complex contract interpretation case will make of them is unsettling.

Unless the trial court requires the jury to fill out a special verdict form, the contract interpretation may be subsumed into a general verdict on the contract cause of action. This was the case in City of Hope, where a lay jury interpreted an ambiguous, complex commercial agreement and returned a nine-figure verdict.

Of course, such verdicts can be appealed. But when the jury has been given the task of interpreting the contract, case law shows that the appellant faces a steep uphill climb. Indeed, one court noted that where “the interpretation of the contract turns upon the credibility of conflicting extrinsic evidence which was properly admitted at trial, an appellate court will uphold any reasonable construction of the contract by the trial court.” (Morey v. Vannucci, 64 Cal. App. 4th 904, 913 (1998).) No standard of review is more deferential. Under that standard, it is hard to conceive of any appellate tribunal overturning a jury’s interpretation.

Trial counsel who understand the foregoing rules have a powerful tool for getting a question of contract interpretation resolved by a jury rather than by the trial judge or an appellate court. Such a tactic will, of course, ordinarily be attractive to the side whose contract interpretation is the least plausible: Counsel with the legally weaker interpretation will argue that there are material extrinsic fact disputes that merit jury determination. For example, there may be a dispute about material discussions during contract negotiation, or a question about the post-contracting conduct of the parties. In other cases, expert testimony about industry custom and practice might be disputed. Skilled counsel will focus on one or more of these kinds of fact disputes to defeat summary judgment and, ultimately, present the issue of contract interpretation to the jury.

To the extent a jury is allowed to interpret a contract – and an appellate court is bound to uphold the jury’s interpretation unless it is completely unreasonable – the law injects a high degree of unpredictability into commercial contractual relationships: As a practical matter, a lay jury will have the last word as to the meaning of a contract that a lawyer negotiated and wrote.

A Juries Procedural Alternative

 In the City of Hope case cited above, appellant Genentech tried to avoid this predicament by arguing that the trial court should have used another procedure: letting the jury resolve the extrinsic fact disputes (using a special verdict form), after which the trial judge interprets the contract. (See Med. Operations Mgmt., Inc. v. Nat’l Health Labs., Inc., 176 Cal. App. 3d 886 (1986).)

This dual procedure takes advantage of the distinct institutional competencies of both the trial judge and the lay jury: The jury resolves the historical fact disputes, and the trial judge then applies established interpretative principles to the contract language in light of the facts found by the jury. If such a case is appealed, the reviewing court would apply the familiar “any substantial evidence” standard to the facts but would review the contract interpretation de novo.

However, the California Supreme Court held in City of Hope that this dual procedure was optional, and its use a matter of trial court discretion (City of Hope, 43 Cal. 4th at 450-452 (2008)). Indeed, the trial judge in City of Hope rejected the idea without explanation, and his ruling was upheld.

Appellant Genentech did not seek review of the case-specific question of whether the jury’s contract interpretation was unreasonable. As noted, decisions such as Morey v. Vannucci have held that when the jury has interpreted the contract because of a material extrinsic fact dispute, the appellate court will “uphold any reasonable construction of the contract by the trial court.” (64 Cal. App. 4th at 913.) The question of whether the court of appeal correctly applied that standard to the particular circumstances of City of Hope would not have met the Supreme Court’s criteria for discretionary review.

But is the Morey standard correct? To be sure, the appellate court will apply the highly deferential “any substantial evidence” standard to the jury’s resolution of factual disputes. And unless the trial court has used the Medical Operations Management special verdict procedure, the appellate court must assume that the jury resolved all material factual disputes in the prevailing party’s favor. (See Whiteley v. Philip Morris, Inc., 117 Cal. App. 4th at 635, 642 & n.3.) But does it follow that the appellate court must also “uphold any reasonable construction of the contract” given by a lay jury?

Maybe not. Appellate courts are quite accustomed to describing the facts favorable to the verdict and judgment. In this context, then, the reviewing tribunal could craft its opinion based on the most favorable view of the disputed facts – both the historical facts (who said and did what) and any disputed extrinsic facts (such as industry custom and practice). Yet there is no requirement that the jury’s interpretation of the contract itself receive comparable deference. Presumably, the appellate court could take the facts determined by the jury (that is, facts favorable to the prevailing party) and then independently review the issue of contract interpretation as a matter of law.

Recent Authority

 A recent ruling endorses this methodology, albeit in an analogous context and without disapproving Morey. In Haworth v. Superior Court (50 Cal. 4th 372 (2010)), the issue was whether a former trial judge, sitting as a neutral arbitrator, had failed to disclose a matter that could cause a reasonable person to question his impartiality. The trial court held that the arbitrator should have made the disclosure. The California Supreme Court eventually ruled that disclosure was not required. Part of its opinion addresses the standard of review, holding that the appellate court should determine the disqualification issue de novo, after giving deferential effect to the trial court’s resolution of disputed facts.

The supreme court considered the issue to involve “a mixed question of law and fact.” (50 Cal. 4th at 384.) The court explained: “[I]n most instances, mixed questions of fact and law are reviewed de novo – with some exceptions, such as when the applicable legal standard provides for a ‘strictly factual test, such as state of mind.’ ” The court further noted that “usually the application of law to fact will require the consideration of legal concepts and involve the exercise of judgment about the values underlying legal principles.” (50 Cal. 4th at 385.)

In light of the court’s statement that appellate review of mixed questions of law and fact is de novo “in most instances,” the deferential standard endorsed by decisions such as Morey v. Vannucci appears open to question.

The Need for Juries Certainty

Further appellate consideration of this issue is urgently needed. When commercial parties enter into contracts, their goal is to have the terms of their relationship determined by their voluntary agreement. They seek certainty and predictability.

Contract ambiguities are common because the fallibility of scriveners prevents negotiators from reaching the utopia of clear and certain contract drafting. But if the parties know that their contract will be interpreted by a trained and experienced judge applying established legal principles, they most certainly will feel more secure than if their fate lies in the hands of a lay jury.

Juries are good at determining disputes over historical facts – Who said what? Who did what? – and perhaps also at resolving competing claims of an industry’s custom and practice. But contract interpretation involves many subtle legal principles and techniques. (See 1 Witkin, Summary of Cal. Law, Contracts §§ 741-758 (10th Ed. 2005).) Juries have no special expertise for that role.

Until the courts harmonize these conflicting lines of cases, the party with the weaker contract interpretation argument has every incentive to create and exploit an extrinsic fact dispute and push for jury interpretation of the contract. Knowing that, what can lawyers – both transactional attorneys as well as litigators – do to protect their clients?

Contract Language

 Counsel who draft contracts should consider inserting language specifying that contract interpretation disputes will be resolved through arbitration by an experienced neutral. As an alternative, a clause could require that contract interpretation disputes be resolved by a judicial referee, which effectively waives a jury trial. (See Cal. Code Civ. Proc. § 638; Grafton Partners LP v. Superior Court, 36 Cal. 4th 944 (2005).)

Counsel might also include a provision acknowledging the City of Hope decision and agreeing that in the event of litigation over interpretation of the contract, the parties will jointly request that the court not allow the jury to interpret the contract and, further, that if extrinsic facts are disputed, the court will submit them to the jury by special interrogatory before interpreting the contract as a matter of law.

However, if the jury was allowed to interpret the contract at trial, counsel should characterize the disputed contractual issues as mixed questions of law and fact in post-trial motions and in appellate briefing. The briefs should urge the appellate court to follow Haworth by deferring to the jury’s presumed findings of fact (that is, by assuming – as appellate courts regularly do – that the jury resolved each fact dispute in favor of the party who prevailed) but affording de novo review to the legal issue of contract interpretation.

Given the complexities surrounding this issue, perhaps the most cogent bit of advice to lawyers is that they draft a contract that is so clear that anyone can understand it – including a lay person who may wind up sitting on a jury.

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Principles of Contract Interpretation

Contract interpretation begins with the plain language of the contract. Gould, Inc. v. United States, 935 F.2d 1271, 1274 (Fed. Cir. 1991); accord Hol-Gar Mfg. Corp. v. United States, 169 Ct. Cl. 384, 390 (1965). A court should first employ a “plain meaning” analysis in any contract dispute. Aleman Food Services, Inc. v. United States, 994 F.2d 819, 822 (Fed. Cir. 1993).

The intention of the parties to a contract controls its interpretation. Firestone Tire & Rubber Co. v. United States, 444 F.2d 547, 551 (Ct. Cl. 1971). In construing the terms of a contract, however, the parties’ intent must be gathered from the instrument as a whole in an attempt to glean the meaning of terms within the contract’s intended context. Kenneth Reed Constr. Corp. v. United States, 475 F.2d 583, 586 (Ct. Cl. 1973); Tilley Constructors v. United States, 15 Cl. Ct. 559, 562 (1988). Contract interpretation requires examination first of the four corners of the written instrument to determine the intent of the parties. Hol-Gar Mfg. Corp. v. United States, 351 F.2d 972 (Ct. Cl. 1965). An interpretation will be rejected if it leaves portions of the contract language useless, inexplicable, inoperative, meaningless, or superfluous. Ball State Univ. v. United States, 488 F.2d 1014 (Ct. Cl. 1973); Blake Constr. Co. Inc. v. United States, 987 F.2d 743, 746-47 (Fed. Cir. 1993).

Ambiguities

A contract term is ambiguous “[i]f more than one meaning is reasonably consistent with the contract language.” Grumman Data Sys. Corp. v. Dalton, 88 F.3d 990, 997 (Fed. Cir. 1996). Ambiguity may be either patent or latent.

A patent ambiguity is “glaring”; it is so obvious from the face of the contract that it would place a reasonable contractor on notice of a discrepancy. Metric Constructors, Inc. v. NASA, 169 F.3d 747, 751 (Fed. Cir. 1999). Patent ambiguities raise an exception to the general rule of contra proferentem, which courts use to construe ambiguities against the drafter: a contractor is under a duty to attempt to resolve a patent ambiguity prior to bidding if the contractor subsequently wishes to rely upon the provision. See e.g., id., Blue & Gold Fleet, L.P. v. United States, 492 F.3d 1308, 1313 (Fed. Cir. 2007).

A latent ambiguity, by contrast, exists where a contract is reasonably, but not obviously, susceptible of more than one interpretation. In the case of a latent ambiguity, the rule of contra proferentem applies to construe the ambiguity against the drafter if the nondrafter’s interpretation is reasonable, and the nondrafter relied upon that interpretation. See Turner Const. Co., Inc. v. United States, 367 F.3d 1319, 1321 (Fed. Cir. 2004); Metric Constructors, 169 F.3d at 751. The reasonableness of an interpretation is determined by ordinary principles of contract construction.

Liquidated Damages Provisions

The parties to a contract may specify in the contract itself the amount of damages to be paid in the event of a breach; these contractually defined damages are known as “liquidated damages.” See generally Restatement (Second) of Contracts § 356. Contractual provisions specifying such damages are enforced if “they are fair and reasonable attempts to fix just compensation for anticipated loss caused by breach of contract.” Priebe & Sons v. United States, 332 U.S. 407, 412 (1947). A liquidated damages clause is particularly appropriate “[w]hen damages are uncertain or difficult to measure,” and the clause will be enforced in such a scenario “as long as ‘the amount stipulated for is not so extravagant, or disproportionate to the amount of property loss, as to show that compensation was not the object aimed at or as to imply fraud, mistake, circumvention, or oppression.'” DF Mfg. Corp. v. United States, 86 F.3d 1130, 1134 (Fed. Cir. 1996) (quoting Wise v. United States, 249 U.S. 361, 365 (1919)).

The challenging party bears the “exacting” burden of demonstrating the unenforceability of a liquidated damages clause. DF Mfg. Corp., 86 F.3d at 1134. Liquidated damages may be recovered even if actual damages are not proved. United States v. Bethlehem Steel Co., supra. Where actual damages are proved, the fact that they may be less, or more, than the amount specified in the liquidated damages clause is insufficient, standing alone, to prove the clause unenforceable. See Printing & Publishing Ass’n v. Moore, 183 U.S. 642 (1902).

Claims Of Mistakes In Bids

If the government knew or should have known of a mistake in a contractor’s bid, and failed to request adequate verification of the bid price before award, the bidder may obtain reformation or rescission of the contract. See Geisler v. United States, 232 F.3d 864, 869 (Fed. Cir. 2000) (citing United States v. Hamilton Enterprises, Inc., 711 F.2d 1038 (Fed. Cir. 1983) and Ruggiero v. United States, 420 F.2d 709 (Ct. Cl. 1970)). A contracting officer who reasonably suspects or should suspect that a mistake has been made must request the bidder to verify the bid, and must inform the bidder of why the request for the verification is being made. See 48 C.F.R. § 14.407-1; Hamilton Enterprises, 711 F.2d at 1045-46 (citing “landmark case” of United States v. Metro Novelty Manufacturing Co., 125 F. Supp. 713 (S.D.N.Y. 1954)). Except where the government has breached its duty to examine the bid for mistakes, the bidder must show that its bid error resulted from a “clear cut clerical or arithmetical error or a misreading of the specifications.” Geisler, 232 F.3d at 869 (citations omitted).

Quasi-Contractual Claims

The United States itself generally is immune from so-called “quasi-contract” claims. Quasi-contracts, also known as contracts “implied in law,” “impose duties that are deemed to arise by operation of law, in order to prevent an injustice.” Lumbermens Mut. Cas. Co. v. United States, 654 F.3d 1305, 1316 (Fed. Cir. 2011) (citing Hercules Inc. v. United States, 516 U.S. 417, 423 (1996) (additional citations omitted)). They can be contrasted with implied in fact contracts, which “are ‘founded upon a meeting of the minds, which, although not embodied in an express contract, is inferred, as a fact, from conduct of the parties.'” Id. (citations omitted). The government’s waiver of sovereign immunity extends only to implied in fact contracts and does not permit claims upon contracts implied in law. Id.; 28 U.S.C. § 1491(a)(1) (Tucker Act waives sovereign immunity only as to claims based “upon any express or implied contract with the United States”); see also id. § 1346(a)(2).

However, the government can proceed against a defendant to recover monies illegally or improperly disbursed, including those disbursed on an erroneous understanding of facts, in a quasi-contractual suit for unjust enrichment. See, e.g., Mt. Sinai Hospital of Greater Miami v. Weinberger, 517 F.2d 329 (5th Cir. 1975); J.W. Bateson Co., Inc. v. United States, 308 F.2d 510, 514-515 (5th Cir. 1962); Kingman Water Co. v. United States, 253 F.2d 588 (9th Cir. 1958); United States v. Independent School District No. 1 of Okmulgee, OK, 209 F.2d 578 (10th Cir. 1954); United States v. Bentley, 107 F.2d 382 (2d Cir. 1939). Similarly, the United States may recover the value of government services provided under a mistake as to the recipient’s eligibility for such services. United States v. Shanks, 384 F.2d 721 (10th Cir. 1967).

No statutory authority is necessary to sustain a suit for public monies which have been erroneously, wrongfully, or illegally disbursed. Fansteel Metallurgical Corp. v. United States, 145 Ct. Cl. 496, 500 (Ct. Cl. 1959); see also United States v. Wurts, 303 U.S. 414, 415 (1938) (“The Government by appropriate action can recover funds which its agents have wrongfully, erroneously, or illegally paid.”); Johnson v. All-State Const., Inc., 329 F.3d 848, 852-53 (Fed. Cir. 2003) (the United States Court of Appeals for the Federal Circuit and its predecessor court “have repeatedly recognized the government’s right of set-off,” which “can be defeated only by explicit language”); Great Am. Ins. Co. v. United States, 492 F.2d 821, 826 (Ct. Cl. 1974) (“The Government’s right to recover funds, from a person who received them by mistake and without right, is not barred unless Congress has ‘clearly manifested its intention’ to raise a statutory barrier” (quoting Wurts, 303 U.S. at 416)). The Government may recover erroneous overpayments through setoff without recourse to the procedures of the Contract Disputes Act. See Applied Cos. v. United States, 144 F.3d 1470, 1478 (Fed. Cir. 1998).

Under certain circumstances, a specified federal official may choose to waive the government’s entitlement to recoup improper payments of: (1) government civilian pay, (2) pay and allowances for member and former members of the uniformed services, and (3) pay and allowances of members and former members of the National Guard under 5 U.S.C. § 5584, 10 U.S.C. § 2774, and 32 U.S.C. § 716, respectively, as interpreted in 4 C.F.R. § 91.1 et seq. Such statutes provide only for discretionary administrative relief and do not impose any legal limitation upon the right of the United States to seek recoupment. See United States v. Kelley, 192 F. Supp. 511, 513 (D. Mass. 1961).

Warranties

  1. Express Warranties

Government contracts frequently contain express warranty clauses. The warranty clause, by its terms, provides the exclusive remedies for nonlatent defects or those not involving fraud or such gross mistakes as amount to fraud, by requiring the contractor to repair or replace the defective article or part, or, if the article or part was retained, by requiring the contractor to pay an amount which is equitable under the circumstances. See United States v. Franklin Steel Products, Inc., 482 F.2d 400, 404 (9th Cir. 1973), cert. denied, 415 U.S. 918 (1974). A frequent defense asserted by contractors in such cases is that the government’s right of inspection before acceptance, under another clause included in such contracts, see 48 C.F.R. § 52.246-2 et seq., relieved the contractors of liability since the government should have inspected, or it negligently inspected, the product or part. However, the inspection clause was added to give the government further protection, not less. United States v. Aerodex, Inc., 469 F.2d 1003 (5th Cir. 1972); United States v. Franklin Steel Products, supra. Assuming, arguendo, that the government had a duty to inspect, the warranty clause specifically provides that inspection and subsequent acceptance are not conclusive as to “latent defects, fraud, or such gross mistakes as to amount to fraud.” Thus, latent defects, not discoverable by visual inspection or the tests specified in the contract, would be the basis for relief in any event. See United States v. Franklin Steel Products, supra at 403.

  1. Implied Warranties
  2. Affirmative Actions Based on Implied Warranties.

Unless specifically forbidden from doing so by regulation or by the contract in question, the government may claim the benefits of implied warranties found in the Uniform Commercial Code (UCC). Although federal law applies to determine the rights and liabilities of parties to a government contract, the Uniform Commercial Code may serve as a guide for federal law in this area, at least to the extent that the question is not governed by the contract or by federal regulations. See United States v. Hext, supra; Everett Plywood & Door Corp. v. United States, 419 F.2d 425 (Ct. Cl. 1969); United States v. Wegematic Corp., 360 F.2d 674 (2d Cir. 1966). The implied warranty of merchantability is found at section 2-314 of the UCC. The implied warranty of fitness for a particular purpose is found at section 2-315. In a proper case, the government may also recover incidental and consequential damages, pursuant to section 2-715 of the UCC. It should be noted that the implied warranties found in sections 2-314 and 2-315 will not apply if, prior to entering into the contract, there was an examination of inspection of the goods by the buyer, unless the defects could not have been reasonably discovered at the time of the examination. U.C.C. § 2-316.

  1. Defenses to Allegations of Implied Warranties

A contractor may not defend or recover on an implied warranty theory where the government expressly disclaims such warranties. Webco Lumber, Inc. v. United States, 677 F.2d 860 (Ct. Cl. 1982). This issue arises most often in contracts which contain an estimate of quantities. Where such estimates are clearly defined as estimates only and any implied warranty is expressly disclaimed, the disclaimer will be given effect. Id.; Caffall Brothers Forest Products, Inc. v. United States, 678 F.2d 1071 (Ct. Cl.), cert. denied, 459 U.S. 908 (1982). To prevail on a claim of breach of warranty, the plaintiff must establish that:

  1. The government assured the plaintiff of the existence of a fact;
  2. The government intended that the plaintiff be relieved of the duty to ascertain the existence of the fact for itself; and
  3. The government’s assurance of that fact proved untrue. See Kolar, Inc. v. United States, 650 F.2d 256 (Ct. Cl. 1981). All implied warranty claims should be viewed in light of the accepted proposition that the government does not normally guarantee the success of a contractor’s operation. Id. For a warranty to exist, there must be either an affirmation of fact or a promise which relates to performance under the contract. American Ship Building Co. v. United States, 654 F.2d 75 (Ct. Cl. 1981). A requirement in a government contract that performance be completed within a specified time is not a guarantee that performance can, in fact, be completed within that time. Id.