Business Law and the Regulation of Business 11th Edition by Richard Mann, Barry Roberts

Exercise 12

FACTS Arrowhead School District No. 75 is located in Park County, Montana, and consists of one school, Arrowhead School (School). For the 1997-98 school year, the School employed eleven full-time teachers and several part-time teachers. During that school year, the School employed James Klyap as a new teacher instructing math, language arts, and physical education for the sixth, seventh, and eighth grades. In addition, Klyap helped start a sports program and coached flag football, basketball, and volleyball. In June 1998, the School offered Klyap a contract for the 1998-99 school year, which he accepted. This contract provided for a $20,500 salary and included a liquidated damages clause. The clause calculated liquidated damages as a percentage of annual salary determined by the date of breach; a breach of contract after July 20, 1998, required payment of 20 percent of salary as damages. Klyap also signed a notice indicating he accepted responsibility for familiarizing himself with the information in the teacher's handbook which also included the liquidated damages clause. On August 12, Klyap informed the School that he would not be returning for the 1998-99 school year even though classes were scheduled to start on August 26. The School then sought to enforce the liquidated damages clause in Klyap's teaching contract for the stipulated amount of $4,100.
After Klyap resigned, the School attempted to find another teacher to take Klyap's place. Although at the time that Klyap was offered his contract the School had eighty potential applicants, only two viable applicants remained available. Right before classes started, the School was able to hire one of those applicants, a lessexperienced teacher, at a salary of $19,500.
After a bench trial, the District Court determined the clause was enforceable because the damages suffered by the School were impractical and extremely difficult to fix. Specifically, the court found the School suffered damages because it had to spend additional time setting up an interview committee, conducting interviews, training the new, less-experienced teacher, and reorganizing the sports program. After concluding that the School took appropriate steps to mitigate its damages, the court awarded judgment in favor of the School in the amount of $4,100. Klyap appealed.
DECISION Judgment affirmed.
OPINION Nelson, J. The fundamental tenet of modern contract law is freedom of contract; parties are free to mutually agree to terms governing their private conduct as long as those terms do not conflict with public laws. [Citation.] This tenet presumes that parties are in the best position to make decisions in their own interest. Normally, in the course of contract interpretation by a court, the court simply gives effect to the agreement between the parties in order to enforce the private law of the contract. [Citation.] When one party breaches the contract, judicial enforcement of the contract ensures the nonbreaching party receives expectancy damages, compensation equal to what that party would receive if the contract were performed. [Citations.] By only awarding expectancy damages rather than additional damages intended to punish the breaching party for failure to perform the contract, court enforcement of private contracts supports the theory of efficient breach. In other words, if it is more efficient for a party to breach a contract and pay expectancy damages in order to enter a superior contract, courts will not interfere by requiring the breaching party to pay more than was due under their contract. [Citation.]
Liquidated damages are, in theory, an extension of these principles. Rather than wait until the occurrence of breach, the parties to a contract are free to agree in advance on a specific damage amount to be paid upon breach. [Citation.] This amount is intended to predetermine expectancy damages. Ideally, this predetermination is intended to make the agreement between the parties more efficient. Rather than requiring a post-breach inquiry into damages between the parties, the breaching party simply pays the nonbreaching party the stipulated amount. Further, in this way, liquidated damages clauses allow parties to estimate damages that are impractical or difficult to prove, as courts cannot enforce expectancy damages without sufficient proof.
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In order to determine whether a clause should be declared a penalty, courts attempt to measure the reasonableness of a liquidated damages clause. *** [T]he threshold indicator of reasonableness is whether the situation involves damages of a type that are impractical or extremely difficult to prove. ***
According to RESTATEMENT § 356 and other treatises, damages must be reasonable in relation to the damages the parties anticipated when the contract was executed or in relation to actual damages resulting from the breach. ***
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Liquidated damages in a personal service contract induce performance by an employee by predetermining compensation to an employer if the employee leaves. However, the employer clearly prefers performance by the specific employee because that employee was chosen for hire. *** Further, because personal service contracts are not enforceable by specific performance, [citation], liquidated damages are an appropriate way for employers to protect their interests. ***
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After reviewing the facts of this case, we hold that while the 20% liquidated damages clause is definitely harsher than most, it is still within Klyap's reasonable expectations and is not unduly oppressive. First, as the School pointed out during testimony, at such a small school teachers are chosen in part depending on how their skills complement those of the other teachers. Therefore, finding someone who would provide services equivalent to Klyap at such a late date would be virtually impossible. This difficulty was born out when only two applicants remained available and the School hired a teacher who was less experienced than Klyap. As a teacher, especially one with experience teaching at that very School, Klyap would have to be aware of the problem finding equivalent services would pose.
Second, besides the loss of equivalent services, the School lost time for preparation for other activities in order to attempt to find equivalent services. As the District Court noted, the School had to spend additional time setting up an interview committee and conducting interviews. Further, the new teacher missed all the staff development training earlier that year so individual training was required. And finally, because Klyap was essential to the sports program, the School had to spend additional time reorganizing the sports program as one sport had to be eliminated with Klyap's loss. These activities all took away from the other school and administrative duties that had been scheduled for that time. ***
Finally, although the School testified it had an intent to secure performance and avoid the above damages by reason of the clause, ***, such an intent does not turn a liquidated damages clause into a penalty unless the amount is unreasonably large and therefore not within reasonable expectations. ***
Therefore, because as a teacher Klyap would know teachers are typically employed for an entire school year and would know how difficult it is to replace equivalent services at such a small rural school, it was within Klyap's reasonable expectations to agree to a contract with a 20% of salary liquidated damages provision for a departure so close to the start of the school year.
*** Accordingly, we hold the District Court correctly determined that the liquidated damages provision was enforceable.
INTERPRETATION A liquidated damages provision is enforceable if it is a reasonable forecast of the harm caused by the breach.
CRITICAL THINKING QUESTION What limitations, if any, should the law impose upon liquidated damages? Explain.