Atrium Med. Ctr., LP v. Hous. Red C LLC

• Decision Date: 07 February 2020
• Docket Number: No. 18-0228,18-0228
• Citation: 595 S.W.3d 188
• Parties: ATRIUM MEDICAL CENTER, LP and Texas Healthcare Alliance LLC, Petitioners, v. HOUSTON RED C LLC d/b/a ImageFIRST Healthcare Laundry Specialists, Respondent
• Court: Texas Supreme Court

595 S.W.3d 188

ATRIUM MEDICAL CENTER, LP and Texas Healthcare Alliance LLC, Petitioners,

v.HOUSTON RED C LLC d/b/a ImageFIRST Healthcare Laundry Specialists, Respondent

No. 18-0228

Supreme Court of Texas.

Argued November 5, 2019

OPINION DELIVERED: February 7, 2020

Justice Bland delivered the opinion of the Court.

In this contract dispute, we determine whether a liquidated damages provision is enforceable. The breaching party seeks to avoid the provision on the ground that it is a penalty. The trial court enforced the provision, ruling that it was not a penalty because it reasonably estimated the harm that would result from a breach, and actual damages were difficult to predict when the contract was made.¹ On those grounds, the court of appeals affirmed.²

Because a provision not designed to be a penalty can nevertheless operate as one, our precedent requires a third step: courts must examine whether, at the time of the breach, an ‘unbridgeable discrepancy‘ exists between actual and liquidated damages.³ Because the breaching party in this case did not prove an unbridgeable discrepancy or otherwise demonstrate that the provision operated as a penalty, we affirm the judgment of the court of appeals.

I

Atrium Medical Center LP⁴ owns and operates a sixty-bed acute care hospital. In a five-year contract, Atrium agreed to pay ImageFIRST Healthcare Laundry Specialists⁵ for specialty laundry services. In exchange, ImageFirst agreed to meet the hospital’s requirements for clean, health-care quality linens. The parties expected that the invoices for these services would vary, depending on Atrium’s weekly linen demand.

Several months into the contract, Atrium experienced financial distress and stopped paying ImageFirst’s invoices.⁶ ImageFirst continued to deliver linens for several more months. But Atrium eventually canceled the contract and entered into an agreement with another vendor. Atrium’s cancellation triggered the liquidated damages provision.

At the outset, the contract defined the "agreement value" to be $2,616.66 per week (the first week’s rental price for the linens). The weekly invoice amount rose in the following months, based on Atrium’s demand. ImageFirst’s final weekly invoice charged $8,066.79. At the time Atrium canceled, approximately four years remained on the contract.⁷

Atrium challenges ImageFirst’s liquidated damages, which are calculated based on the remaining weeks of the contract term. The contract required Atrium to pay a cancellation charge equal to 40 percent of the greater of (i) the initial "agreement value" and (ii) the current invoice amount, multiplied by the number of weeks remaining in the agreement’s term:

The length of this agreement is for sixty (60) months from the date of the first delivery and therefore⁸ for the same time period unless cancelled by either party, in writing, at least ninety (90) days prior to any termination date. The terms of this contract shall apply to all subsequent increases or additions to such service. There will be a minimum weekly billing of 60% of this agreement value or 60% of the current invoice amount whichever is greater. Customer may discontinue service at any time provided customer pays Company a cancellation charge of 40% of the agreement value or the current invoice amount, whichever is greater, multiplied by the number of weeks remaining under this agreement. The customer agrees that this cancellation charge is not punitive, but a reimbursement to Company for related investments to service the customer. Customer agrees to pay attorneys fees and cost[s] necessary to collect monies due.

Atrium further contends that the provision limits ImageFirst to reimbursement for the linens and supplies purchased to service Atrium, less the cost of linens repurposed for another customer.

The trial court ruled that the liquidated damages provision was not a penalty and that ImageFirst was entitled to its contractual profit. The court calculated the amount owed based on Atrium’s last weekly invoice because "ImageFirst’s last invoice of $8.066.79 to Atrium [was] greater than the original Contract amount of $2,616.66." The court then determined that "ImageFirst [was] entitled to recover 40% of the last invoice multiplied by the 222-weeks remaining under the Contract, totaling $716,330.95."⁹

The court of appeals affirmed the award of liquidated damages.¹⁰ Based on the trial court’s findings, it held that, at the time of contracting, actual damages "were very difficult, if not impossible to determine," because this requirements contract depended upon Atrium’s uncertain needs:

(a) the parties knew the volume of laundry services would fluctuate over time as the census changed and given the needs of individual patients; (b) the parties could not predict how long linens would last; (c) the parties could not determine the frequency of deliveries that would be required to service Atrium’s account; (d) the parties could not determine Atrium’s rate of loss of [ImageFirst’s] linens; and (e) the parties could not determine the amount of [ImageFirst’s] general overhead expenses and resources that would be expended to service Atrium’s account.¹¹

The court of appeals also explained that the 40 percent cancellation charge was not a penalty because "the evidence of record demonstrated that 40% was a reasonable forecast" of the harm resulting from canceling the contract.¹² It rejected Atrium’s interpretation that the cancellation provision limited ImageFirst to its reliance damages.¹³ We granted review.

II

Texas favors freedom of contract, as a policy "firmly embedded in our jurisprudence."¹⁴ But tempering this policy is the "universal rule" that damages for breach of contract are limited to "just compensation for the loss or damage actually sustained." Stewart v. Basey , 150 Tex. 666, 245 S.W.2d 484, 486 (1952). Accordingly, courts carefully review liquidated damages provisions to ensure that they "adhere to the principle of just compensation."¹⁵

In keeping with this approach, an enforceable liquidated damages contract provision establishes an "acceptable measure of damages that parties stipulate in advance will be assessed in the event of a contract breach."¹⁶ A damages provision that violates the rule of just compensation, however, and functions as a penalty, is unenforceable.¹⁷ Liquidated damages must not be punitive, neither in design nor operation.¹⁸

In Phillips v. Phillips , we emphasized that courts will enforce liquidated damages provisions when: (1) "the harm caused by the breach is incapable or difficult of estimation," and (2) "the amount of liquidated damages called for is a reasonable forecast of just compensation."¹⁹ In applying the first two rules, courts examine the circumstances at the time the agreement is made.²⁰ The party seeking liquidated damages bears the burden of showing that the provision, as drafted, accounts for these two considerations.²¹

A properly designed liquidated damages provision, however, may still operate as a penalty due to unanticipated events arising during the life of a contract. Thus, we observed in Phillips that courts must also examine whether "the actual damages incurred were much less" than the liquidated damages imposed, measured at the time of the breach.²²

When a contract’s damages estimate proves inaccurate, and a significant difference exists between actual and liquidated damages, a court must not enforce the provision. Applying this rule in FPL Energy, LLC v. TXU Portfolio Mgmt. Co. , we held that the "unacceptable disparity" between damages assessed under the contract (approximately $29 million) and actual damages (approximately $6 million) made the liquidated damages provision unenforceable.²³ At the time of contracting, damages from a breach in that case "were difficult to estimate" and the liquidated damages provision "on [its] face, reasonably forecast damages."²⁴ Nonetheless, we held the provision unenforceable because it "operate[d] with no rational relationship to actual damages."²⁵ When an "unbridgeable discrepancy" exists between "liquidated damages provisions as written and the unfortunate reality in application," the provisions are not enforceable.²⁶ To avail itself of this defense, the breaching party challenging a provision must demonstrate this unbridgeable discrepancy.²⁷

In addition to claiming that the provision is unenforceable, Atrium further contends that the trial court and the court of appeals misinterpreted the provision by upholding a recovery of a contractual profit, i.e., ImageFirst’s expectancy damages. American law traditionally recognizes three types of recovery to compensate for a breach of contract: expectancy, reliance, and restitution damages.²⁸ Expectancy damages award a contract plaintiff the benefit of its bargain; reliance damages compensate the plaintiff for out-of-pocket expenses; and restitution damages restore to the plaintiff a benefit that it had conferred on the defendant.²⁹

Bearing these principles in mind, we turn to whether the cancellation provision in this case is enforceable and allows for a recovery of a contractual profit.

III

A

Ryan Steen, president of ImageFirst, testified that, at the time the parties made their agreement, it was difficult to estimate the damages that would result if Atrium canceled the contract. At the time of trial, Steen had worked for ImageFirst for 11 years and had performed under approximately 120 contracts in two markets, including Houston. He explained that a customer’s "burn rate" of linens—the percent of linens that must be discarded per cycle because they are stained or otherwise unusable—is unknown and difficult to calculate at the outset. And a customer’s patient load can fluctuate, making Atrium’s weekly demand for linens unpredictable. All this, in turn, affected ImageFirst’s ability to forecast its weekly gross margin.

As it turned out, Atrium’s patient load increased in the first months of the contract. ImageFirst escalated its deliveries to...