Are Cell Service Early Termination Fees Too High or Too Low?

lost cell phoneWhat happened to debate about cell phone subscriber contracts containing early termination fees? Companies and subscribers sign multi-year term contracts, exchanging service for monthly and other fees. Contracts provide that customers terminating early breach and owe damages, usually a flat fee of between $150-225. Companies claim these fees partly compensate them for costs like subsidizing handsets to customers, but customers assert these fees coerce them to continue in an unwanted relationship.

Debate manifested in numerous class action lawsuits, state attorney general investigations under state consumer protection laws, federal legislators circulating bills to curtail the fees, and July 2008 Federal Communications Commission hearings and suggestions for compromise. Much of this energy has dissipated, perhaps partly because some companies have modified some of their contracts, including by adjusting the fee according to when in the term a customer terminates. But not all companies have adjusted and not all contracts have been changed.

Lawsuits continue to wind their way through courts, involving issues ranging from subscriber assertions of unjust enrichment to violation of consumer protection laws. A particularly interesting issue concerns whether the clauses are enforceable under the general common law of contracts. One of the few cases to have resulted in a judicial opinion on the merits grappled extensively with this issue, which turns out to be more complex than one may suppose. Ayyad v. Sprint Spectrum (Cal. Super., Alameda County 2008.)

The court, in a class action, found the clauses unenforceable, though not because they charged subscribers too much, but mainly because the company’s losses from breach by early termination were greater (plus, more generally, the fees did not reflect a compensatory impulse, shown further by how they did not vary with the time of subscriber breach).

This result may be surprising for two reasons. First, as a matter of traditional contract law, concern focuses more on stipulated damages that overcompensate and thus penalize breach rather than those that under-compensate. Second, as a matter of fact, is it likely that company losses from subscriber breach exceed $150-225 per subscriber, on average or on particular contracts?

Legal remedies for breach of contract are designed to compensate aggrieved parties for loss. Within this compensation principle, doctrine shows greater aversion to over-compensation, as by denying losses for emotional distress or punitive damages, rather than under-compensation, reflected in limitations on the compensation principle barring recovery for losses avoidable, unforeseeable or not provable with reasonable certainty.

Law allows parties to express their own remedies by contract, stating sums to be paid by a breaching party to the other upon designated breaches. But law jealously reserves power to police stipulated remedy amounts for reasonableness. Standard tests of enforceability insist that actual damages be difficult to prove with reasonable certainty and that the stipulated sum is reasonable in relation to forecast or actual damages.

Doctrinal talk distinguishes between enforceable clauses by calling them liquidated damages and unenforceable clauses by calling them penalties, nomenclature reflecting contract law’s historically greater aversion to over-compensating than under-compensating aggrieved parties, concentrating the penalty inquiry on how much the breaching party must pay on breach.

But what about stipulated damages clauses that are too small to compensate an aggrieved party’s losses, not a penalty on the breacher but a functional penalty on the aggrieved party? Such cases are less frequent and traditional doctrine, such as the Restatement (Second) of Contracts, does not talk about them.

Its Section 356(1) announces: “A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.” Professor Farnsworth, in his treatise, wrote: “Since it is the in terrorem effect that is objectionable, the proscription applies only if the stipulated sum is on the high, rather than the low, side of conventional damages . . . .”

The few cases calling stipulated damages clauses invalid when too low, rather than too high, often involve other considerations. For example making a real estate buyer’s damages 10% of the purchase price when seller sold the property for a gain 3.5 times that was held invalid. Wilt v. Waterfield (Missouri 1954). Perhaps this was because it was too low, but also because it was invariant to the gravity of the breach, raising doubt about whether it was intended to compensate.

Likewise, though rare, burglar alarm subscribers have recovered actual damages from alarm companies who negligently breach contracts, rather than a much lower stipulated sum. Samson Sales, Inc. v. Honeywell (Ohio 1984). Though traditional contract law can be applied, even calling the low sum a penalty, the negligence feature may warrant departure or relaxation of standard contract law tools.

More recently, and more generally, revised Article II of the UCC is amended to speak not only of damages too high, as before, but also damages too low, something new.

Add to this list the Sprint cell phone case. Though damages were difficult to prove with reasonable certainty, meeting prong one of the traditional test, the sum was not reasonable in relation to forecast or actual damages, lacking suggestion of a compensatory objective.

Aside from being invariant to the gravity of breach (the same flat fee applied without regard to how much time remained on a contract when a subscriber terminated), the main objection was how the sums were too low in relation to the company’s probable forecast or actual losses.

Determining a cell service provider’s actual losses from early subscriber termination is difficult and the estimates of party experts in the litigation differed radically. There is general agreement that the best compensatory measure is the company’s lost profits from subscriber breach.  All also agree that generally means estimating the company’s lost revenue less costs it avoided as a result of the breach.

Lost revenues can be comparatively easier to estimate, based on factors like contract price, minutes charged, usage and so on. The cost side generates intense dispute about classifying costs as fixed or variable, a perennial challenge in calculating contract damages. Fixed costs cannot be avoided after breach, and are included in compensatory damages, but variable costs can be avoided, so are excluded from compensatory damages.

Unsurprisingly, the subscribers’ expert witness offered to show that nearly all costs varied, and got per customer lost profits down to below $10. If believed, 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 convinced the court that most costs were fixed, not variable, showing lost profits per customer averaged some $525, vastly more than the stipulated damages, ranging from $150-225 per customer. On this basis, the clause was invalid, and customers owed the company damages far greater than the stipulated amount.

Among costs not avoidable as a result of breach, were subsidies companies gave to new customers, like handsets at prices less than cost and free or discounted months of service. As a policy matter, the companies also say this business model, using term contracts, subsidies and termination fees, was essential to the proliferation of cell phones and service to huge numbers of people, in all economic backgrounds, and resulting value of a massive network of users. Benefits radiate throughout the economy, domestically and internationally.

Absent these tools, including the early termination fees, companies say they would have to use a different business model, one that would raise prices, reduce affordability of phones and services, contract the size of the cell phone network, and retard all associated economic gains arising from the current model.

This may also explain why debate seems to have dissipated—though many subscribers still fume at these terms. And the dueling expert arguments about costs avoided are just the first reaching adjudication. They leave a nagging sense that the disparity suggests we are much farther away from the truth than this single judgment suggests.

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