Sprint ETFs Invalidated on Appeal

Earlier this month a California appellate court affirmed a lower court ruling invalidating early termination fees in cell phone service contracts.  The affirmance stressed different reasoning than the lower court (which I discussed here). To the appellate court, Sprint’s ETFs were invalid because it set them without regard for their relation to the company’s actual damages; the trial court rested its ruling in part on how the fees were vastly lower than Sprint’s actual damages.  

In a dozen lawsuits nationwide, champions of cell phone customers argued that ETFs penalize them by trapping them with a single provider. Most of the lawsuits settled before final resolution and few judicial opinions addressed the merits. The Sprint case is an exception.  Both sides agreed that Sprint’s damages would be difficult to determine with reasonable certainty, meeting prong one of the traditional test for the validity of liquidated damages clauses. 

Proponents of liquidated damages clauses, especially in consumer contracts, must show that they made a reasonable endeavor to set them with some relation to actual damages, however difficult they are to fix. Inquiry focuses on both what the party intended and the effects. In Sprint’s case, it couldn’t point to any intention to relate the ETFs to its losses. Rather, the entire ETF program was created and implemented by the company’s marketing department as a way to keep customers. Though Sprint may not have intended to set fees exceeding losses, as it contended, that argument gained it nothing because it showed no intention whatsoever concerning the relationship between the ETFs and its losses.

Its intention aside, Sprint stressed that the effect was clear: the clause undercompensated Sprint and that means it cannot possibly be a penalty to the customer. Here the two sides offered diametrically opposing expert testimony on how to estimate Sprint’s losses upon customer breach by early termination. Experts agreed that the best compensatory measure is the company’s lost profits from subscriber breach, which means estimating the company’s lost revenue less costs it avoided as a result of the breach. Lost revenues, based on factors like contract price, minutes charged, and usage, are relatively easy to estimate. In contrast, the cost side is more complex, requiring the perennial challenge of classifying costs as fixed or variable.

Fixed costs cannot be avoided after breach, so are included in compensatory damages; variable costs can be avoided, so are excluded from compensatory damages. Unsurprisingly, the customers’ expert witness testified that nearly all costs varied, and got per-customer lost profits down to below $10. According to the customers, the stipulated sums over-compensated, amounted to a penalty, were unenforceable, and breaching subscribers would owe at most about $10 for any breach. But the company proved that most costs were fixed, not variable, showing that lost profits per customer averaged $525 to $650, vastly more than the stipulated ETFs. Among costs unavoidable as a result of breach were costs companies incurred when subsidizing phones.

For the court, the trouble with Sprint’s argument is how it makes an ex post rationalization substitute for the ex ante focus of the “reasonable endeavor” test. The court said it is not enough that it turns out that a company makes no money from a stipulated remedy. Proponents of a liquidated damages clause must show they made some determination of that sort when they created the clause. Sprint didn’t do that and could not have, since the whole plan was a marketing device with “an entirely deterrent purpose and focus.”

It did Sprint no good to stress that its ETFs benefited customers rather than penalized them. It didn’t matter that the arrangement enabled Sprint to subsidize handsets and reduce monthly rates. Nor did it matter that applying the usual tests—requiring the reasonable endeavor—would expose customers to greater liability for higher damages than under the ETF. The purpose of the rule isn’t necessarily to insulate people from paying higher damages. Its purpose is to demand reasonable estimates ahead of time, not enable shifting the focus toward a contest about the effects after the fact.

The rule would be meaningless otherwise, the court reasoned. Applying the test to this case, as in any other, promotes an important function of liquidated damages clauses: reducing uncertainty about damages determinations in litigation. True, Sprint may be right that the ETFs turn out to be a better deal for customers than paying actual damages. But, as the court summed up: “institutional intuition is not a substitute for analytical evaluation and retrospective rationalization does not excuse the objective assessment required at the inception of the contract.”

Though thus affirming the trial judge’s ruling, it is interesting to note that the trial court used slightly different reasoning. A principal reason the trial court held the clauses invalid wasn’t that they charged subscribers too much, but too little—the company’s losses from breach by early termination were greater. As many classic cases suggest, contract law’s primary concern with stipulated remedies concerns punishment. It invalidates clauses that spur rather than compensate. This doctrine flags terms fixing unreasonably large, rather than unreasonably small, sums.

There have been few cases invalidating clauses for under-compensating rather than over-compensating and they are usually accompanied by other factors, like a party acting negligently. But as courts in many of the classic opinions also noted, like porridge that shouldn’t be too hot or too cold, damages for breach of contract should compensate breach, neither more nor less. And recent trends show increased frequency of stated remedy clauses that are invalid because they pay too little rather than too much. The trial court’s stance is part of that trend, though the appellate court did not abide it.

Citation: In re Cellphone Fee Termination Cases, 193 Cal. App. 4th 298, — Cal.Rptr.3d —-, 2011 WL 743462 (Cal. App. 1 Dist. March 4, 2011).

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