Contracts often contemplate periodic payments over a fixed term, and frequently require the payment of a pre-determined early termination fee if the client terminates the contract early. For some time, New York courts enforced these types of liquidated damage provisions, especially if the provision was negotiated at arms-length by sophisticated parties when the contract was signed. Recently, however, a federal court held that a party terminating a contract prior to the end of the fixed term of the contract might be entitled to recover the early termination fee it paid if the fee operated as a penalty. This case could be a signal that courts will more carefully scrutinize early termination fees.
Spirit Locker, Inc. v. EVO Direct, LLC involved a dispute between a retailer, Spirit Locker, and a credit card processing company, EVO. Spirit Locker agreed to pay EVO a monthly fee for processing services over a three-year period. Spirit Locker agreed to pay an early termination fee of $395 if it, without cause, terminated the contract before the expiration of the term. The contract provided that the early termination fee was not a penalty, and stated that $350 was a reasonable estimate of EVO's damages, but did not explain why. Three months into the contract, Spirit Locker terminated without cause, and EVO automatically debited the early termination fee from Spirit Locker's on-file account. Spirit Locker filed suit on behalf of itself and other similarly situated companies, seeking recovery of all early termination fees they paid and claiming that these fees unjustly enriched EVO. The court ruled against EVO's motion to dismiss the complaint as a matter of law, holding that Spirit Locker could have a claim for unjust enrichment if the early termination fee was an unenforceable penalty.
Although the court was not asked to determine whether the early termination fee was a penalty, it quoted heavily from a 1977 New York Court of Appeals decision, Truck Rent-A-Center. In that case, the court carefully scrutinized the liquidated damage provision. Recognizing a strong public policy against the imposition of penalties, the court enforced the damage provision only because of its reasonableness. In the years since that case, New York courts have moved away from rigidly interpreting liquidated damages provisions, and have more readily enforced these provisions as long as they were fairly negotiated. The Spirit Locker court did not appear inclined to follow this more recent trend, possibly signaling that early termination fees may be subject to closer scrutiny in the future.
>> The Bottom Line
Liquidated damage provisions should be carefully drafted, not only to prevent a finding of an unenforceable penalty, but also to avoid an unjust enrichment claim seeking repayment of the fee. A contract that simply characterizes an early termination fee as liquidated damages may not be enough to prevent a court from construing the fee as an unenforceable penalty, even if the contract states that the fee should not be considered a penalty. Provisions establishing early termination fees should provide details regarding how the fee was calculated, and explain how this calculation provides a reasonable estimate of the non-terminating party's loss. In other words, a little bit of detail can ensure that the contract is enforced as desired.
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