Xco Intern. Inc. v. Pacific Scientific Co., 03-1683.

• Decision Date: 24 May 2004
• Docket Number: No. 03-2405.,No. 03-1825.,No. 03-1683.,03-1683.,03-1825.,03-2405.
• Citation: 369 F.3d 998
• Parties: XCO INTERNATIONAL INC., Plaintiff-Appellant/Cross-Appellee, v. PACIFIC SCIENTIFIC COMPANY, Defendant-Appellee/Cross-Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

369 F.3d 998

XCO INTERNATIONAL INC., Plaintiff-Appellant/Cross-Appellee, v. PACIFIC SCIENTIFIC COMPANY, Defendant-Appellee/Cross-Appellant.

No. 03-1683.

No. 03-1825.

No. 03-2405.

United States Court of Appeals, Seventh Circuit.

Argued December 3, 2003.

Decided May 24, 2004.

Rehearing and Rehearing En Banc Denied June 24, 2004.

Thomas J. Ramsdell (Argued), Marshall, Gerstein & Borun, Chicago, IL, for Plaintiff-Appellant/Cross-Appellee.

Michael P. Siavelis (Argued), John A. Childers, Johnson & Bell, Chicago, IL, for Defendant-Appellee/Cross-Appellant.

Before FLAUM, Chief Judge, and POSNER and WILLIAMS, Circuit Judges.

POSNER, Circuit Judge.

The appeal in this diversity breach of contract suit governed mainly by Illinois law presents issues involving the enforceability of a liquidated damages clause (found by the district judge to be a penalty), contract interpretation, patent law, and sanctions for making frivolous claims.

The plaintiff, XCO, owned U.S. and foreign (mainly European) patents on heat-sensitive cables. In 1991 it assigned the patents to the defendant, PacSci, which wanted to use them in making products for fire control and related uses. PacSci agreed to pay XCO $725,000 down, plus $100,000 or 5 percent of PacSci's sales of products utilizing the patented technology — whichever amount was greater — annually from 1995 through 2000; after that it would pay 5 percent of annual sales until the patents expired. As part of the deal, PacSci licensed the patents that it had just bought back to XCO for use in making heat-sensitive cables for lining refractory process vessels (used for processing petroleum products), which was the core of XCO's business, its principal market being in Europe. As the consideration for this license XCO agreed to pay PacSci $100,000 plus royalties on sales of the cables for the licensed use. The parties further agreed that PacSci would be "responsible for all expenses of any kind relating to" the patent rights that it was buying, including the fees charged by European patent authorities to maintain patents in effect. The U.S. Patent and Trademark Office charges patent-maintenance fees for U.S. patents, but payment of those fees is not in issue.

The agreement was to continue until the last of the patents expired in 2003. Beginning in 1993, however, just two years after the agreement had been signed, PacSci stopped paying maintenance fees on those patents that it wasn't using. It took the position that notwithstanding the "responsibility" clause of the contract, it could pick and choose which patents to keep alive. As a result, by 1998 a number of the patents had lapsed. XCO declared a breach that year and terminated the contract, as it was entitled to do (without liability) if in fact PacSci had committed a breach. A provision in a section of the contract captioned "Breach and Liquidated Damages" states that in the event of such a termination all money owed XCO by PacSci, "including such amounts which constitute overdue, delinquent or otherwise unpaid amounts ... plus one hundred thousand dollars ($100,000) per year from and including the year of such termination to and including the year of the last to expire of the patent rights, shall then constitute liquidated damages under this Agreement." Another provision, also in the "Breach and Liquidated Damages" section, states that if XCO breaks the contract, PacSci will have no further obligations except to pay XCO any amounts that came due before the breach; in other words, from the date of a breach by XCO forward, PacSci would have a royalty-free license. So damages were specified for a breach by either party.

Because XCO terminated the contract in 1998 and the last patent expired in 2003, and because the $100,000 in liquidated damages was due in both the year in which the contract was terminated and the year in which the last patent expired, as well as in all the intermediate years, the clause, if valid, entitles XCO to $600,000 in damages. The district judge held that it is a penalty clause, hence invalid. He ruled so on summary judgment, while rejecting PacSci's interpretation of the "responsibility" clause. He found, in other words, that PacSci had broken the contract; but since XCO did not attempt to prove its actual damages, instead seeking only liquidated damages, XCO got no relief for the breach.

There is also a counterclaim. Beginning in 1998 XCO had begun manufacturing a somewhat different kind of heat-sensitive cable, for which it has applied for a patent. PacSci counterclaimed for royalties on XCO's sales of the new cable, citing a clause in the contract which states that PacSci is purchasing not only the patents listed in the contract but also "all purchasing, manufacturing, marketing, sales and installation information and materials including know-how, drawings, sketches, plans, designs, specifications, data, methods, processes, techniques, inventions or discoveries whether patentable or not which relate in any way to the Products covered by the Patent Rights" (emphasis added). Another clause, however, provides that if "any such additional proprietary subject matter is first conceived and/or reduced to practice by or on behalf of [XCO] during the term of this Agreement, then title thereto shall vest in and remain [XCO's] exclusive property." The district judge rejected the counterclaim, and PacSci has appealed that ruling. But the judge also rejected XCO's request for sanctions for the filing of the counterclaim; XCO had argued that the counterclaim was frivolous and in addition that PacSci was trying to inject into the case an issue of patent law — namely whether XCO's new patent (if issued) would infringe patents that it had assigned to PacSci — without complying with the standards laid down by the Federal Circuit for proving infringement. XCO claims to have incurred nearly $400,000 in legal fees and other expenses to defend against the counterclaim.

XCO's appeal challenges the district judge's denial of its motion for sanctions as well as his refusal to enforce the liquidated damages clause. In defending the latter ruling PacSci not only embraces the judge's penalty-clause determination but also argues that letting the patents lapse was not a breach of contract after all.

When damages for breach of contract would be difficult for a court to determine after the breach occurs, it makes sense for the parties to specify in the contract itself what the damages for a breach shall be; this reduces uncertainty and litigation costs and economizes on judicial resources as well. Indeed, even if damages wouldn't be difficult to determine after the fact, it is hard to see why the parties shouldn't be allowed to substitute their own ex ante determination for the ex post determination of a court. Damages would be just another contract provision that parties would be permitted to negotiate under the general rubric of freedom of contract. One could even think of a liquidated damages clause as a partial settlement, as in cases in which damages are stipulated and trial confined to liability issues. And of course settlements are favored.

Yet it is a rule of the common law of contracts, in Illinois as elsewhere, that unless the parties' ex ante estimate of damages is reasonable, their liquidated damages provision is unenforceable, as constituting a penalty intended to "force" performance. Bauer v. Sawyer, 8 Ill.2d 351, 134 N.E.2d 329, 333 (1956); Checkers Eight Ltd. Partnership v. Hawkins, 241 F.3d 558, 561-62 (7th Cir.2001) (Illinois law); Lake River Corp. v. Carborundum Co., 769 F.2d 1284, 1289-90 (7th Cir.1985) (same); Med+Plus Neck & Back Pain Center, S.C. v. Noffsinger, 311 Ill.App.3d 853, 244 Ill.Dec. 712, 726 N.E.2d 687, 693 (2000); see also Truck Rent-A-Center, Inc. v. Puritan Farms 2nd, Inc., 41 N.Y.2d 420, 393 N.Y.S.2d 365, 361 N.E.2d 1015, 1017-19 (1977). The reason for the rule is mysterious; it is one of the abiding mysteries of the common law. At least in a case such as this, where both parties are substantial commercial enterprises (ironically, it is the larger firm, PacSci, that is crying "penalty clause"), and where damages are liquidated for breach by either party, making an inference of fraud or duress implausible, it is difficult to see why the law should take an interest in whether the estimate of harm underlying the liquidation of damages is reasonable. Courts don't review the other provisions of contracts for reasonableness; why this one?

It is true that if there is a very stiff penalty for breach, parties will be discouraged from committing "efficient" breaches, that is, breaches that confer a greater benefit on the contract breaker than on the victim of the breach, in which event breach plus compensation for the victim produces a net gain with no losers and should be encouraged. (This is a reason why injunctions are not routinely granted in contract cases — why, in other words, the party who breaks his contract is usually allowed to walk away from it, provided only that he compensates the other party for the cost of the breach to that party.) But against this consideration must be set the worthwhile effect of a penalty as a signal that the party subject to it is likely to perform his contract promise. This makes him a more attractive contract partner, since if he doesn't perform he will be punished severely. His willingness to assume that risk signals his confidence that he will be able to perform and thus avoid the penalty. It makes him a credible person to do business with, and thus promotes commerce.

Granted, the case for a contractual specification of damages is stronger the more difficult it is to estimate damages and so the greater the expense to the parties and the judiciary, and hence to society, of determining the plaintiff's damages by the clumsy and costly methods of litigation. That presumably is why the enforceability of liquidated damages clauses depends on the difficulty of...