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Liquidated Damages as Unenforceable Contract Breach Penalty – The Nebraska Court of Appeals Weighs In

In the May 23, 2017 decision in the case of Computer Support Services (d/b/a Cyzap) v. Vaccination Services (d/b/a TotalWellness), the Nebraska Court of Appeals considered whether a liquidated damages provision in a contract was enforceable.  In this case, an IT vendor called Cyzap had entered into an arrangement with TotalWellness to provide it with IT services.  At the beginning of the parties' relationship in 2000, there was no written contract between the parties.  In 2002, the parties entered into a more structured arrangement which included a partnership to develop a web-based online scheduling service, with Cyzap providing the IT services and TotalWellness providing the marketing and sales efforts, and a continuation of the general IT services TotalWellness was receiving from Cyzap, for which TotalWellness agreed to pay $400 per month.

In 2009, the parties started a new business venture called the "Health Risk Assessment."  The parties signed a written contract under which Cyzap would provide the venture with IT services and TotalWellness would pay Cyzap $2,917 per month for the new services.  In addition, Cyzap would continue to provide general IT services to TotalWellness for the same $400 per month fee.

In 2012, the parties began discussions to terminate their partnership for the web-based online scheduling services.  Around the same time, TotalWellness notified Cyzap that it no longer needed Cyzap's IT services for the Health Risk Assessment product, and that it would only need the general IT services it had been receiving for $400 per month.  In October 2012, Cyzap ceased providing all services to TotalWellness, believing it was owed a substantial amount of money for the IT services it had provided to TotalWellness for the Health Risk Assessment product under that contract.  

Shortly thereafter, the parties negotiated and signed a new agreement, and Cyzap resumed providing general IT services for TotalWellness.  This agreement became the source of the dispute between the parties.  Under this agreement, TotalWellness agreed to pay Cyzap $3,500 per month for IT services, including hosting and support services.  The agreement began on October 1, 2012, and automatically renewed for additional one-year terms unless either party gave the other 120 days' advance notice of termination (which would have required notice to be given by June 1).  Note, that under this type of auto-renewal clause, if a party misses the window to terminate, the party is typically "stuck" for another year.  

The agreement also stated that TotalWellness could terminate the agreement at any time, but if it did so without giving the required notice, and as long as Cyzap itself was not in breach, then TotalWellness would owe Cyzap liquidated damages equal to the fees that TotalWellness would otherwise have owed to Cyzap under the agreement until the end of the then-current term.

TotalWellness provided notice to Cyzap on September 3, 2013 (and outside of the window for termination without cause) that it was terminating the agreement "immediately" and that it believed that it had signed the agreement under "significant duress" because at the time it was essentially being held hostage by Cyzap because Cyzap had cut off all IT services and TotalWellness had needed Cyzap to reconnect those services as soon as possible.  On November 21, 2013, Cyzap sued TotalWellness for $45,500 in liquidated damages because the agreement had automatically renewed and TotalWellness had not provided proper notice for termination without liquidated damages.  

Cyzap argued that it was entitled to the liquidated damages under the agreement because once the agreement had automatically renewed, Cyzap had incurred expenses in preparation for providing another year of services to TotalWellness, including renewing its Internet connection and continuing to operate an Omaha-based data center with employees that it would otherwise have terminated.  In response, on the issue of liquidated damages, TotalWellness argued that Cyzap did not incur any actual damages, and that in fact, Cyzap had saved money by not having to perform its services any longer, because Cyzap's costs for providing the services exceeded the fees TotalWellness was paying.

The Nebraska District Court for Douglas County found that the liquidated damages provision in the agreement was an unenforceable penalty, and granted TotalWellness summary judgment on that issue. Cyzap appealed.    

In its appeal, Cyzap argued that the liquidated damages provision was enforceable because it required TotalWellness to pay an easily calculable amount of liquidated damages in the event of an early termination.  Cyzap argued that the court need not even analyze whether the clause was an unenforceable penalty provision because TotalWellness was not actually in "breach" of the agreement, since it had the contractual right to terminate early and pay the liquidated damages.  The Nebraska Court of Appeals did not find that argument persuasive, and stated that the early termination by TotalWellness did constitute a breach under the agreement, even though the agreement allowed TotalWellness to do so.  

The court of appeals explained that the Nebraska Supreme Court has described an enforceable liquidated damages provision as one (i) where the damages of the parties might be difficult to determine because of their indefiniteness or uncertainty and (ii) where the amount to be paid is either a reasonable estimate of actual damages or reasonably proportionate to what actual damages might have been under the breach.  The district court had found that the $45,500 amount Cyzap had sued for was neither a reasonable estimate of its damages nor reasonably proportionate to what its damages would have been, and the court of appeals agreed.  

The court of appeals noted that Cyzap had offered into evidence a spreadsheet listing all of its costs associated with the early termination, including an early termination fee for Internet services, employee wages, rent and equipment maintenance.  The court stated those actual damages, in the amount of $21,045.37, were less than half the amount that would have been owed by TotalWellness under the liquidated damages set forth under the agreement.  In addition, the court of appeals noted there was some evidence that Cyzap did have more costs than revenue in providing the services to TotalWellness, even at the increased fees set forth in the 2012 agreement, and that Cyzap therefore saved money due to TotalWellness's early termination.  The court of appeals agreed with the district court's opinion that "A liquidated damages clause is not intended to provide a windfall, as it would in this case, but rather it is to justly compensate a party for damages that are difficult to measure."  The court of appeals affirmed the district court's holding that the liquidated damages provision in the parties' agreement constituted an unenforceable penalty provision.  On June 22, 2017, Cyzap petitioned the Nebraska Supreme Court to review the court of appeal's decision holding the liquidated damages provision was an unenforceable penalty, arguing that the holding contradicts a 2008 court of appeals' decision in Berens & Tate, P.C. v. Iron Mountain Information Mgmt., Inc. that determined an early withdrawal of records (with accompanying withdrawal fees) did not constitute a breach of contract under which a liquidated damages/unenforceable penalty analysis could be conducted.

This case may provide an opportunity for a party "stuck" in a contract with a vendor that has auto-renewed and that has a liquidated damages provision to argue that it should only be required to pay actual damages relating to the early termination rather than the liquidated damages amount, if the liquidated damages amount is not reasonably close to the actual damages that would be incurred.  This case arguably has applicability even where the contract at issue does not call the early termination penalty a "liquidated damages" clause.  

Of course, we caution that this case is very fact-specific and we do not advise that you proceed with breaching a contract with provisions like this without consulting legal counsel.  In Cyzap's petition seeking review by the Nebraska Supreme Court, Cyzap argued that these types of provisions are common in business arrangements and that the court of appeals' holding should be reviewed by the Supreme Court to provide clarity to Nebraska businesses.       

Kimberly A. Lammers

 

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