October 3, 2012

The enforceability of limitation of liability provisions

Posted in Commercial Litigation by Gene Killian |

Commercial contracts such as loan documents can get pretty complicated.  When things go badly, debtors are always looking for ways around the strict language of the contract.  We recently had a case, for example, in which construction loan documents contained a $1.4 million holdback, to be released when all retail space in a shopping center was developed and open to the public for business.  The anchor tenant (Wal-Mart), which had a “big box” store on the premises, leased an additional 6,250 square feet of noncontiguous retail space. The space remained empty (with no electricity, lights or signage, although the developer-debtor thoughtfully positioned a pallet of cat food inside to try to show that the space was open for business).  The developer demanded release of the $1.4 million on the ground that the conditions had been “substantially complied with” despite the empty store; our client said no; and off to Court we went.  Justice was done, and the debtor has now appealed to the Third Circuit.

Under some circumstances, though, relying upon strict contract terms will be deemed a breach of contract.   The poster child for this in New Jersey is Borden v. Sons of Thunder, 148 N.J. 296 (1997).  In Borden, a food conglomerate took advantage of a commercial clammer by agreeing to purchase certain minimum quantities of clams, and encouraging the clammer to take on debt to buy new equipment.  But Borden didn’t buy the required amounts of clams, and then “pulled the plug,” invoking termination provisions in the contract and destroying the clammer’s business.  The court upheld a $412,000 jury verdict against Borden, representing approximately one year’s profit to the clammer, writing:  “The obligation to perform in good faith exists in every contract, including those contracts that contain express and unambiguous provisions permitting either party to terminate the contract without cause.”     

Normally, though, in contracts between sophisticated parties, borrowers don’t have the right to read lender-friendly provisions out of the document.   In the recent case of FiveStar Development Resort Communities v. iStar RC Paradise Valley, LLC, for example, the borrower (“FiveStar”) contended that the lender (“iStar”) had breached its contract and committed fraud, basically by refusing to comply with contract requirements to advance funds.  The lender moved to dismiss the borrower’s consequential damages claims, based upon an “exculpatory clause,” or limitation of liability provision, in the loan document.  The clause read:  “Lender shall have no liability hereunder for any consequential, punitive, special or indirect damages.”  

The lender had agreed to provide $112M in financing for a multi-use project anchored by a Ritz-Carlton Hotel.  On the closing date, the lender disbursed $50M.  The project fell behind schedule, and the lender became worried about its viability, and stopped complying with draw requests, claiming that certain conditions precedent to the release of loan funds had not been met.  For purposes of the lender’s summary judgment motion, the Court assumed that the lender had deliberately breached the contract, to gain economic advantage at the borrower’s expense.  The question was whether consequential damages such as anticipated profits could be recovered by the borrower.  

The Court granted the lender’s motion and dismissed the borrower’s claims for consequential damages, holding that the “limitation of liability” clause was essentially a mechanism for allocation of risk in the event of a breach of contract. The Court wrote:  “The risk of economic harm stemming from deliberate non-performance that is motivated by the economic self-interest of the breaching party is...the sort of risk assumed by the commercial counterparty to an exculpatory clause.” (Citations omitted.)  The Court noted that “an exculpatory clause is [only] unenforceable when, in contravention of accepted norms of morality, the misconduct for which it would grant immunity smacks of intentional wrongdoing.”  (Citation omitted.)

So:  an intentional breach of contract is not enough to invalidate an exculpatory clause, at least under New York law.  More is needed - enough to breach “accepted norms of morality.”  (How’s that for murky?)  In the Sons of Thunder case (decided under New Jersey law and not dealing with this specific issue, but instructive nonetheless), Borden had a gross disparity in bargaining power, got intimately involved in the affairs of its much smaller counterpart, and actively encouraged the other party to the contract to take on more debt…then backed out of the contract, causing the smaller company to go bankrupt.  Presumably that would be enough to invalidate an exculpatory clause.

The takeaway is that if there isn’t fraud or a pretty serious breach of the duty of good faith and fair dealing, the exculpatory clause will stand.

You can read the full FiveStar decision here.