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Edward X. Clinton, Jr.

The Clinton Law Firm

Ed, I want to go into this new business, but I am worried that something could go wrong, or that I will get sued.

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If you do anything in America enough times or sell anything, you are almost certain to get sued. We may be able to limit the exposures and protect you and your company from some types of claims.

Limit your clients liability in contracts. !! Understand the tools that lawyers use or should use to limit and/or manage such liability. !! Four main areas of this discussion:
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!! Limitations of Liability !! Waiver of consequential damages !! Liquidated damages and penalty clauses !! Indemnities

Often the various types of clauses are used together in the same contract. !! Example: Often times a limitation of liability clause will also have a waiver of consequential damages clauses and a liquidated damages provision. !! As we shall discuss later on, this is a good thing.
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Rule:

!! In keeping with the principle of freedom of contract, contractual limitations are generally held valid in this State,unless it would be against the settled public policy of the State to do so, or there is something in the social relationship of the parties to the contract militating against upholding the agreementIn the absence of a legislative directive to the contrary, exculpatory provisions must be deemed valid and enforceable.
!! River North Ins. v. James O. Jones, 655 N.E.2d 987, Ill. App. 3d 175 (1s Dist. 1997).

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What does this mean?


!! Inkeeper !! Landlord

!! Our great state prohibits certain parties from limiting their liability for negligence, such as: !! These prohibitions are located in the Illinois statutes.

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The North River Insurance case: A dispute between insurance companies and Holmes Protection of Illinois. Holmes was an alarm company. It built and designed a fire alarm system, which was installed in a building. Two years later, the building burned down.

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The insurance companies sued Holmes, who relied on its limitation of liability clause in its contract. The clause is lengthy but the first sentence or two are really important:

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Purchaser acknowledges that Holmes is not an insurer; that insurance shall be obtained by Purchaser, if any is desired; that the sum payable hereunder to Holmes by Purchaser are based upon the value of services offered and the scope of liability undertaken, and such sums are not related to the value of the property belonging to the Purchaser

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So, Holmes is telling the owner of the building, We are not in the insurance business, we are in the alarm business. The clause is particularly well-drafted because it limits liability, prohibits consequential damages and provides a liquidated damages clause and most importantly, the clause explains to the Court why its a terrible idea to impose liability on the alarm company. The Court then understands why liability is being limited and, accordingly, enforces the provision.

Hopefully, anyone reading the contract can understand why the alarm company inserted that provision- because it is not an insurance company and it is not paid nearly enough to pay that loss. !! Caveat: Remember, the contract clause limiting liability will not apply to a third party. !! Thus, if the client causes an injury to a third party, the clause is of no value at all.
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Consequential and special damages are damages that are the consequence of special or unusual circumstances which are in the reasonable contemplation of the parties when making the contract.
!! See Hanumadass v. Coffield, Ungaretti & Harris, 311 Ill. App. 3d 94, 724 N.E.2d 14, 18 (1st Dist. 1999).

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scary.

damages are

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They keep contract lawyers awake at night because the damage award can be enormous.

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The most scary form of consequential damages is lost profits.

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Lost profits can be recovered when:

(a)! The plaintiff can prove the damages to a reasonable degree of certainty; (b)! The plaintiff can prove that the breach directly caused the damages; (c)! The plaintiff can prove that the lost profits were within the reasonable contemplation of the parties.

Obviously, many contracts include a waiver of consequential damages. !! All software contracts include such a waiver because software can malfunction or crash and damage can be caused when that occurs.
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An example from the Itunes license agreement:

IN NO CASE SHALL APPLE, ITS DIRECTORS, OFFICERS, EMPLOYEES, AFFILIATES, AGENTS, CONTRACTORS, PRINCIPALS, OR LICENSORS BE LIABLE FOR ANY DIRECT, INDIRECT, INCIDENTAL, PUNITIVE, SPECIAL, OR CONSEQUENTIAL DAMAGES ARISING FROM YOUR USE OF ANY OF THE SERVICES OR FOR ANY OTHER CLAIM RELATED IN ANY WAY TO YOUR USE OF THE SERVICES, INCLUDING, BUT NOT LIMITED TO, ANY ERRORS OR OMISSIONS IN ANY CONTENT, OR ANY LOSS OR DAMAGE OF ANY KIND INCURRED AS A RESULT OF THE USE OF ANY CONTENT (OR PRODUCT) POSTED, TRANSMITTED, OR OTHERWISE MADE AVAILABLE VIA THE SERVICES, EVEN IF ADVISED OF THEIR POSSIBILITY. BECAUSE SOME STATES OR JURISDICTIONS DO NOT ALLOW THE EXCLUSION OR THE LIMITATION OF LIABILITY FOR CONSEQUENTIAL OR INCIDENTAL DAMAGES, IN SUCH STATES OR JURISDICTIONS, APPLES LIABILITY SHALL BE LIMITED TO THE EXTENT PERMITTED BY LAW.

Similar waivers of consequential damages are included in almost every software or services contract. Software companies know that almost anything can go wrong with software programs and the liability could be disastrous.

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The most important requirement is that the purchaser of the goods had the ability to review the waiver of consequential damages before purchasing the goods. See Converting Systems, Inc. v. Hot-Line Freight System, Inc., 344 Ill. App. 3d 1037, 801 N.E.2d 155 (1st Dist. 2003); Magee v. Walbro, 525 N.E.2d 975 (1988)(in bailment case, the limitation of liability was ineffective where the customer had no knowledge of the term before agreeing to store her fur coat with the defendant.)

Razor v. Hyundai Motor America, 854 N.E.2d 607 (2006). Plaintiff purchased a Hyundai and sued alleging that the car was defective and sought modest damages: (a) $5,000 in diminution of value; and (b) $3,500 in consequential damages. Hyundai refused to settle this small case and managed to harm the business community in doing so. !! The Illinois Supreme Court held that the consequential damages waiver was unconscionable.
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The decisive fact for the Court, however, was the lack of evidence that the warranty, which contained the disclaimer of consequential damages, had been made available to the plaintiff on or before the time she signed the contract. 854 N.E.2d at 623. !! Hyundais argument that the limitation was printed in capital letters and was written in plain English did not sway the Court.
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Thus, make sure your clients understand that any waiver of consequential damages is provided to the customer before the item is purchased or the goods are delivered.

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Brief Detour to the law of Software Contracts ! Here we are going to discuss an old case, ProCD v. Zeidenberg, 86 F.3d 1447 (7th Cir. 1996) where the Seventh Circuit held that a license agreement on shrink-wrap was valid binding and enforceable. The customer had the opportunity to read the license and decline to buy the product. ! Move forward a few years Now no one uses shrinkwrap. Instead, you have to click on the license before you use the software. If you dont click you do not get to use the product.

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Sometimes your client will ask or express the concern that a contract could be terminated sooner than the client anticipates and that the client will thereby incur a substantial loss. Example: A client agrees to open a new location or make modifications to real estate, only to find out that the other party terminates the contract shortly after the relationship begins. One approach the lawyer may take is to add a liquidated damages provision to the contract that will, in theory, make the client whole, or limit the clients loss, if things do not go as planned.

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This is a difficult area of the law, an area that has produced numerous contradictory decisions over time. In 1917, the Illinois Supreme Court said: This court has said more than once that no branch of the law is involved in more obscurity by contradictory decisions than whether a sum specified in an agreement to secure performance will be treated as a liquidated damages or a penalty and that each case must depend on its own peculiar and attendant circumstances Giesecke v. Cullerton, 280 Ill. 510, 513 (1917).

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Risk No. 1: Liquidated damages clauses are subject to scrutiny in Illinois.

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Illinois courts will attempt to determine if the liquidated damages clause is a penalty or a liquidated damages clause.
!! If the clause is deemed a penalty, it is void and unenforceable. !! If the clause is one for liquidated damages, it is enforceable.

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Remember: The determination of whether a contractual provision for damages is a valid liquidated damages provision or a penalty clause is a question of law. Grossinger Motorcorp, Inc. v. American National Bank & Trust Co., 240 Ill. App. 3d 737, 749, 607 N.E.2d 133 (1992).

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The test:

!! A liquidated damages clause is valid and enforceable when all three factors are present: (1)! The parties intended to agree in advance to the settlement of damages that might arise from the breach; (2)! The amount of liquidated damages was reasonable at the time of contracting, bearing some relation to the damages which might be sustained; and (3)! Actual damages would be uncertain in amount and difficult to prove. See Grossinger, 240 Ill. App. 3d at 749; See also the Restatement of Contracts (Second) Section 356(1).

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Caveat: The damages must be a specified amount for a specific breach, not a penalty to punish for nonperformance or as a means to secure performance. See Grossinger, 240 Ill. App. 3d at 750. Risk No. 2: If you are too greedy, your clause will not be enforceable.

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An example of a poorly drafted clause in an employment contract:

Early Termination. The parties hereto agree that, in the event that [defendant] terminates this Agreement prior to the completion of the Subsequent Term, [plaintiff] shall be entitled to receive from [defendant] an amount which compensates [plaintiff] for the cost of training. Upon the execution of this Agreement, [defendant] shall execute and deliver to [plaintiff] a promissory notein the principal amount of Fifty Thousand Dollars ($50,000). The Note shall provide that the principal amountwill be reduced by $2,083.33 per month for each of the twentyfour (24) months of theTerm of this Agreement.

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Holding:

!! The clause was a penalty because it bore no relation to the actual training costs. Indeed, the award was inversely related to the amount of training costs. !! If the employee quit the first day (when minimal training costs had been incurred), he would be liable for $50,000. !! However, if the employee quit on the last day, he would owe $2,083.33, after two years of training.

Risk No. 3: Illinois law does not permit the use of an optional liquidated damages clause. !! Example: If buyer breaches the contract, buyer agrees to forfeit the earnest money, or, at the option of the seller, pay sellers actual damages. !! To paraphrase a Florida court, you cannot have your cake and eat it too.
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Illinois courts reject such liquidated damages clauses that give one party the option to accept the liquidated damages amount or take its remedy. As on court notes, this scheme distorts the very essence of liquidated damages, which in effect is to provide the parties with a pre-ordained settlement of the damage sum when actual damages would otherwise be difficult to determine. Catholic Charities v. Thorpe, 318 Ill. App. 3d 304, 741 N.E.2d 651 (Ill. App. 1st Dist. 2000). In most cases, courts do not get involved in the nitty gritty of contract provisions. They are reluctant to rewrite contracts. In this area, however, courts frequently rewrite contracts by eliminating the liquidated damages clause.

Warnock v. Patterson, (1st Dist. 2007). The First district recognized a cause of action against a lawyer who included a liquidated damages clause and an actual damages clause in a real estate contract. The plaintiff lost the ability to take the earnest money because of the lawyers error. !! !
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Many commentators have criticized the liquidated damages/penalty cases on the grounds that: (a) The cases demonstrate extraordinary judicial management of the bargains of private parties, even where each side had a lawyer; (b) Even small dollar value liquidated damages provisions are often scrutinized; (c) For those who are litigators, consider a frontal attack on these cases argue that the cases are inconsistent with basic principles of freedom of contract.

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Penalty clauses are bad because they hinder efficient breach. Here I quote Blacks Law Dictionary: efficient breach theory is "the view that a party should be allowed to breach a contract and pay damages, if doing so would be more economically efficient than performing under the contract." Breaching a contract is not wrong or bad and it should not be punished. So its not wrong to breach and liquidated damages clauses that have onerous penalties should be subject to judicial review.

No one should ever rely on a liquidated damages provision and believe that the client is protected Courts too often decide that their ideas of what is right and wrong are binding even though the parties agreed otherwise. !! One area where liquidated damages clauses have had some success is in the defense of claims.
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Instead of using the liquidated damages clause as a remedy, use it as a fallback defense. Our example is a client in the environmental consulting business. Limitation of Liability: Buyer agrees that Client shall not be liable for consequential damages, pain and suffering damages or lost profits. Buyer agrees to limit Clients liability to Buyer and anyone allegedly relying on Clients services to a sum not to exceed Clients fees for the services performed on the project, provided that such claims are not attributable to Clients gross negligence of willful and wanton conduct.

The addition of a liquidated damages provision (Buyer agrees to limit Clients liability a sum not to exceed Clients fees) gives the Client a second defense to a lawsuit. !! The lawyer drafting this clause has added a moat inside the wall of the castle.
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Illinois enforces contract of indemnification and the courts construe them to give effect to the intention of the parties. !! With respect to construction contracts, the Legislature has barred the parties to those contracts from any provision indemnifying a party for its own negligence. 740 ILCS 35/1 !! However, in all other contexts, you can enter into a contract that indemnifies you for your own negligence.
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Illinois courts prohibit agreements to indemnify an individual for willful misconduct because such an agreement is against public policy. Wright v. City of Danville, 174 Ill.2d 391 (1996).

One area that I have been involved in many times as a litigator is litigation arising out of the sale of a business. !! When the business is sold, the Buyer will request that the agreement contain certain representations and warranties. !! Those representations and warranties are the fuel for future litigation brought by the Buyer against your client, the Seller.
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The books and accounting records of ACME company have been prepared in accordance with generally accepted accounting principles, or GAAP. ! ACME is compliance with all laws and regulations of the State of Illinois. ! Another provision of the Agreement will state that: ! Seller agrees to indemnify Buyer if any of the representations shall prove to be false.

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The question arises can the Buyer sue for indemnification even where the Buyer knew of a problem or a liability before the Closing? That is known as a sandbagging issue. I have personally worked on several litigation matters where the claim for breach of warranty was known to Buyer before it closed on the purchase.

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Anti-Sandbagging Clause Buyer acknowledges that it has had the opportunity to conduct due diligence and investigation with respect to the Company, and in no event shall Seller have any liability to Buyer with respect to a breach of representation or warranty under this Agreement to the extent that Buyer knew of such a breach as of the Closing Date.

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Pro-Sandbagging Clause The rights of Buyer to indemnification or any other remedy under this Agreement shall not be impacted or limited by any knowledge that Buyer may have acquired, or could have acquired, before the Closing Date.Seller hereby acknowledges that, regardless of any investigation made (or not made) by or on behalf of Seller, and regardless of the results of any such investigation, Buyer has entered into this transaction in express reliance upon the representations and warranties of the Seller made in this Agreement.

We add the anti-sandbagging clause because often the Seller of a business may not prepare their books and records in a way that meets with modern practice. !! Often business owners forget that someone else will look at the dispute in a different light.
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I found several sources very helpful: Kenneth Clarkson, Roger LeRoy Miller and Timothy Muris, Liquidated Damages v. Penalties: Sense or Nonsense, 1978 Wis. L. Rev. 351 (1978) Aristides N. Hatzis, Having the cake and Eathing it too: efficient penalty clauses in Common and Civil contract law, International Review of Law and Economics 22 (2003) 381-406 Edward Hoffman, Liquidated Damages in Illinois Contracts, 45 Chicago-Kent Law Review Issue 2, Article 5

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IICLE Contract Law 2013, including Chapter 13 - Rights, Legal Remedies and Calculating Damages for Breach of Contract, by Shermin Kruse, Jessica Perez Simmons, and Brandon Prosansky, Chapter 4 Void Contracts or Clauses under Illinois Statutes, Gregory J. Rastatter, Chapter 5 Problems in Contract Formation, Darren C. Baker Anti-Sandbagging Clauses - Daniel Avery of Goulston and Storrs, and Daniel H. Weintraub, Audax Group. Bloomberg law reports.

Thank you! !! Contact information:


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Edward X. Clinton, Jr. The Clinton Law Firm 111 W. Washington Street, Suite 1437 Chicago, Illinois 60602 (312) 357-1515 edwardclinton@icloud.com