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Texas Supreme Court Update

Texas Supreme Court Update: Liquidated but Perhaps Invalidated
HF – Working

Henry Flores

Senior Counsel

On February 7, 2020, the Texas Supreme Court issued a decision in Atrium Medical Center, LP et al. v. Houston Red LLC d/b/a ImageFIRST Healthcare Laundry Specialists, affirming the enforcement of a liquidated damages clause against a breaching party that failed to meet its burden of proof regarding one of the three factors that Texas courts must consider in determining whether a liquidated damages provision constitutes an unenforceable penalty. This case is the latest in a recent string of Texas Supreme Court opinions that will interest commercial litigators and those lawyers who assist their clients in negotiating and documenting deals.

The quick takeaways?

For deal lawyers. When negotiating and drafting a liquidated damages provision, discuss with your client what aspects of the proposed commercial relationship will make it difficult to determine actual monetary loss in the event the counterparty breaches the agreement. If it isn’t difficult to determine actual loss, or if the liquidated damages are merely punitive or are intended to deter breach, the provision won’t be upheld in a later dispute.

Further, even if the provision is reasonable at the outset, your client should understand that a Texas court might still decline to enforce it later, if the facts give rise to a damage award that is “unacceptably disparate” from actual loss.

For trial lawyers. Beyond the liquidated damages lesson, the case is a good refresher regarding relative and shifting burdens of proof, and the need for laser-like focus on the factual building blocks that you need to provide or undermine to win your case. The opinion is replete with references to unrebutted evidence and includes a rejection of market data that the defendant offered for the first time on appeal instead of at trial. Understand the elements of your claim or defense and give the fact finder the proof on each of the required elements.

The facts of the case are fairly simple. Atrium and ImageFIRST entered into a 60-month contract under which ImageFIRST provided medical laundry and linen services to Atrium’s hospital.  Suffering severe financial distress, Atrium breached by terminating the contract with 48 months of the original term remaining.

ImageFIRST sued, and the trial court enforced the liquidated damage clause in the contract, which required Atrium to pay 40% of the greater of (1) the initial “agreement value,” and (2) the current invoice amount, multiplied by the number of weeks remaining under the contract. The court calculated damages to be $716,330.95, by taking 40% of the last outstanding weekly invoice and multiplying it by the number of weeks left under the contract.

Atrium appealed, challenging the application of the liquidated damages clause. The court of appeals affirmed, holding that the liquidated damages clause was a “reasonable forecast” of the harm resulting from breach. The Texas Supreme Court granted review because the court of appeals did not consider whether, in application as opposed to design, the liquidated damages formula created an “unbridgeable discrepancy” between actual and liquidated damages.

Citing its 1979 holding in Phillips v. Phillips, the Court first noted that Texas courts will enforce a liquidated damages provision when (1) estimation of the harm caused by breach is impossible or difficult, and (2) the liquidated damages are a reasonable forecast of just compensation. The party seeking damages bears the burden of proving that the liquidated damages provision, as drafted and when drafted, accounts for these two considerations.

The Court then noted that even if the plaintiff proves that the disputed provision meets the two-part Phillips test, Texas courts must also consider whether the facts give rise to an “unacceptable disparity” or an “unbridgeable discrepancy” between the liquidated damages and the actual harm caused by the breach. Notably, the breaching party bears the burden of proving that the disparity exists.

The Court considered the trial record to address whether the ImageFIRST met its burden on the first two issues:

  • ImageFirst’s president testified at trial. The president had worked for ImageFIRST for 11 years and had negotiated 120 similar agreements.
  • The president testified that a customer’s demand fluctuates widely due to changing patient count.
  • The president also testified that the customer’s “burn rate” for percentage of linens that must be destroyed due to stains or other patient-driven circumstances is unknown and difficult to calculate.

 

The Court then noted that Atrium offered no evidence rebutting the president’s testimony. The Court also rejected Atrium’s effort to demonstrate that the invoices themselves establish that the damages were easily calculated.  Under Texas law, difficulty of estimation is determined based on circumstances existing at the time of contract formation, not later during the relationship.  Given the record, ImageFIRST had met its burden on the first part of the Phillips test.

Turning to the second part of the Phillips test, the Court observed that ImageFIRST demonstrated that the liquidated damage figure represented a reasonable forecast by providing evidence of its own historical profit margin from over 40 years of experience in the industry, and its profit margin during the window of its relationship with Atrium.

Atrium produced no rebuttal evidence. Instead, it argued that ImageFIRST’s use of the same 40% contract figure in all of its contracts was per se unreasonable.  On appeal (but not at trial), Atrium also sought to rebut this proof by referring to publications showing different industrial profit margins. The Court rejected both of these efforts, holding that the use of form contract language is permitted if other evidence shows that the damages estimate is reasonable (as the evidence showed in this case). The Court flatly declined to consider Atrium’s untimely offer of contrary industry data (“Atrium did not present these publications to the trial court. We do not consider them.”).

Having concluded that ImageFIRST met its burden under Phillips, the Court turned to whether Atrium met its burden to demonstrate an “unbridgeable gap” between the liquidated damages award and actual harm (this is the test that the Court of Appeals did not apply). In unequivocal terms, the Court concluded that Atrium failed to meet its burden:

  • Atrium offered no evidence showing that the liquidated damages were unreasonably disparate from the plaintiff’s actual expectancy damages.
  • Atrium offered no evidence showing that mitigation would have reduced actual damages such that the liquidated damage award was unreasonable.
  • Although the plaintiff’s evidence created an inference that some mitigation had occurred, Atrium failed to present evidence showing the dollar value created by the plaintiff’s actions, or whether the plaintiff’s actions materially reduced its expectancy damages.

 

The liquidated damages provision was reasonable at the time the contract was made and the defendant presented no evidence showing that the provision created an unreasonable windfall for the plaintiff. The Court affirmed the lower court rulings. Again, this case is a good one for all commercial lawyers to read.  Transactional lawyers need to understand the facts that might justify the inclusion of a liquidated damages provision in a contract. Trial lawyers need to understand the elements involved in the dispute and the burden of proof at each stage, and develop a plan to present that evidence at trial.

You can find the Atrium opinion Here. The Texas Supreme Court has also issued two other recent and interesting opinions in commercial disputes. You can read our summaries of those cases here: Update I, Update II.

DISCLAIMER

Rapp & Krock, PC presents the information in this article for general education purposes only. Although this article discusses legal issues, it is not legal advice. The law and the content of any linked website may have changed since this article was written, and Rapp & Krock, PC makes no warranty or guarantee about the continuing accuracy of the information presented. Use of this article does not create an attorney-client relationship, and Rapp & Krock, PC does not represent you unless and until we are expressly retained in writing.

Copyright © 2020 by Henry Flores. All rights reserved.