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Contract Drafting Concerns

April 13, 2017 (13 min read)

By: Timothy Murray, Murray, Hogue & Lannis.

RECENTLY A TEXAS COURT CONSTRUED A CONTRACT replete with common provisions designed to limit the supplier’s financial exposure in the event of its breach and proceeded to hold every one of them inoperative in the interest of fairness. CGBM 100 v. Flowserve US, 2016 U.S. Dist. LEXIS 179517 (S.D. Tex. December 29, 2016) is a cautionary tale about the limitations of contract drafting, and every attorney who drafts contracts could benefit by understanding its lessons.

The Case1

Plaintiffs were under contract with CITGO (not a party in the case) to load two barges with coker feed, transport it across a waterway, and then unload it. To perform the CITGO contract, plaintiffs needed four pumps capable of pumping coker feed at a flow rate of 3,500 gallons per minute.

The defendant, Flowserve, assured plaintiffs that even though its standard pumps did not meet the required flow rate, Flowserve could redesign its standard pumps to meet plaintiffs’ specifications. Based on Flowserve’s assurances, plaintiffs entered into a contract to purchase the pumps from Flowserve at a cost of $1.3 million.

Flowserve’s promise to achieve the required flow rate was not included in the parties’ written contract. The parties’ written contract contained all manner of standard provisions designed to limit Flowserve’s financial exposure in the event of its breach. These included:

  • A disclaimer of warranty clause
  • A merger or integration clause
  • A clause limiting plaintiffs’ remedies to repair or replace the pumps, at Flowserve’s option
  • A damages cap limiting monetary damages to the price of the pumps
  • A clause excluding any liability on Flowserve’s part for “special, consequential, incidental or penal damages”

After the pumps were installed, plaintiffs claimed they failed to achieve the required flow rate. According to plaintiffs, Flowserve, contrary to its promises, had not redesigned its standard pumps prior to installation but merely made minor and inadequate adjustments to them and instructed plaintiffs to run the pumps at a higher-than-normal speed. This method proved inadequate and caused severe vibrations to the barges.

Flowserve attempted, without success, to repair the pumps before demanding what the court would later call “substantial sums of money from Plaintiffs to continue its repair efforts . . . .” When plaintiffs refused to pay, Flowserve stopped working on the pumps. The alleged breach caused plaintiffs to incur approximately $2.5 million in damages to retain the services of a company to temporarily perform its CITGO contract and another company to redesign the pumps to perform as required.

Plaintiffs sued Flowserve for, inter alia, breach of express warranty and fraud. Flowserve moved for summary judgment and argued that its alleged promises regarding the pumps’ capabilities were barred by the contract’s disclaimer and merger clauses and that plaintiffs’ damages were limited by the clear terms of the contract. The court disagreed.

The Court Holds That Provisions Designed to Protect Flowserve Were Inoperative

The court held that the jury could find each of the clauses that ostensibly protected Flowserve was ineffective to shield Flowserve from the consequences of its breach.

The Disclaimer of Warranty Did Not Disclaim the Warranty

The court held that Flowserve’s promise to achieve the required flow rate constituted an express warranty, and “[t]hat promise was the primary basis of the bargain upon which Plaintiffs relied in authorizing the purchase of the pumps.”

But the contract also contained a disclaimer of warranty clause that “would negate or limit that warranty” (the court did not quote the actual language). The court concluded it could not reconcile the warranty with the disclaimer, so according to the clear words of U.C.C. § 2-316(1), the disclaimer was inoperative. See also U.C.C. § 2-313, Official Comment 4 (“A clause generally disclaiming ‘all warranties, express or implied’ cannot reduce the seller’s obligation with respect to such description and therefore cannot be given literal effect under Section 2-316.”).

The lesson is clear: a party cannot both give, and disclaim, an express warranty.

The Merger Clause Did Not Negate the Prior Oral Warranty

The contract also contained a merger or integration clause designed to signal that the written contract is the complete and exclusive statement of the terms of the parties’ agreement.

The court held that the merger clause did not bar consideration of Flowserve’s prior oral warranty, saying that the merger clause can offer Flowserve no escape since it cannot be seriously contended that plaintiffs intended the written contract to be a complete and exclusive statement of the terms of the agreement. The warranty was a basis of the parties’ bargain, the court explained, so the merger clause could not undo it.

The treatment of merger clauses varies from jurisdiction to jurisdiction. “. . . [M]ost contemporary viewers of contract are unwilling to accept the doctrinaire” view that merger clauses are “conclusive, except for mistakes, fraud and attempts at reformation.” Corbin on Contracts § 25.8 (2016).2 “According to the Restatement (Second) of Contracts and most major writers, a merger clause should not be treated as definitive, but should be given weight based on the circumstances under which it was adopted, including the complexity and sophistication of the contract and the parties.” Corbin on Contracts § 25.8 (2016).

Plaintiffs also pleaded a claim for fraud, and the court refused to dismiss it on summary judgment despite the merger clause. The majority of jurisdictions hold that fraud, without restriction, is admissible to challenge the validity of a written agreement. Riverisland Cold Storage, Inc. v. Fresno-Madera Production Credit Assn., 55 Cal. 4th 1169, 1171, 291 P.3d 316, 317, 151 Cal. Rptr. 3d 93, 94,2013 Cal. LEXIS 253, *1 (Cal. 2013).

The contract at issue did not contain a non-reliance clause in addition to a merger clause (the two clauses are often paired together). While it is far from certain that inclusion of such a clause would have been dispositive, the court suggested it might have. “The merger clause does not express Plaintiffs’ intent to disclaim reliance on Flowserve’s representations and, instead, to rely upon their own judgment,” the court wrote. Another court3 recently explained that “non-reliance,” “no-reliance,” or “anti-reliance” clauses “state that the parties to the contract did not rely upon statements or representations not contained within the document itself,” which “has the binding effect of negating an action based on fraud in the inducement. Although some courts have adopted a contrary approach, this appears to be the rule in the majority of jurisdictions.”

The Court Disregarded (1) the Clause Limiting Plaintiffs’ Remedies to Repair or Replacement of the Pumps, (2) the Damages Cap, and (3) the Exclusion of Consequential and Incidental Damages

Based on the facts before it, the court held that a jury could conclude that the limited remedy spelled out by the contract failed of its essential purpose and did not provide a “fair quantum of remedy” to plaintiffs. The court opened the door for the jury to award damages far in excess of what the contract, as written, ostensibly allowed.

Failure of Essential Purpose

Under U.C.C. § 2-719(2), “[w]here circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in this Act.” This means that when a contract spells out an exclusive, limited remedy, if the seller fails to provide the remedy, the U.C.C.’s default monetary remedies (including not just direct damages but consequential and incidental damages as well) are restored.

The court invoked the failure of essential purpose concept here even though, in addition to the repair or replacement remedy, the contract also permitted limited money damages up to the price of the pumps ($1.3 million). There is some judicial reluctance to invoke the concept where money damages are available. See, e.g., Fish Net, Inc. v. Profitcenter Software, Inc., 2013 U.S. Dist. LEXIS 148661, *29 (E.D. Pa. Oct. 15, 2013) (remedy did not fail of its essential purpose since the contract allowed limited money damages). But see Marvin Lumber & Cedar Co. v. Sapa Extrusions, Inc., 964 F. Supp. 2d 993,996, 2013 U.S. Dist. LEXIS 108700, *1, 81 U.C.C. Rep. Serv. 2d (Callaghan) 279 (D. Minn. 2013) (“limiting damages to the purchase price would essentially amount to no remedy at all and fails of its essential purpose.”).4

Fair Quantum of Remedy

The court also held that that the jury was entitled to disregard the contract’s limited remedies because they did not provide a “fair quantum of remedy” to the aggrieved plaintiffs.

The implication is that even when an otherwise valid contract spells out a limited remedy, the limited remedy will not be operative if it isn’t “fair.”

It might seem jarring to modern practitioners, steeped in the traditions of freedom of contract, that a court could invalidate a mutually agreed-upon provision that is not unconscionable on the basis of fairness. But this isn’t a rationale that the CGBM court invented from whole cloth. The Official Comments to the U.C.C. state, inter alia:

. . . it is of the very essence of a sales contract that at least minimum adequate remedies be available . . . . [T]here [must] be at least a fair quantum of remedy for breach of the obligations or duties outlined in the contract. . . . . [W]here an apparently fair and reasonable clause because of circumstances fails in its purpose or operates to deprive either party of the substantial value of the bargain, it must give way to the general remedy provisions of this Article.

U.C.C. § 2-719 cmt. 1.

Indeed, a contractual provision that limits the remedy to direct damages or a money back guarantee may be invalidated if it does not place the aggrieved party in the position it would have occupied had the contract been performed. See, e.g., Marvin Lumber & Cedar Co. v. Sapa Extrusions, Inc., 964 F. Supp. 2d 993 (D. Minn. 2013); Holbrook v. Louisiana-Pacific Corp., 2015 U.S. Dist. LEXIS 35862(N.D. Ohio Mar. 23, 2015); E.F. Johnson Co. v. Infinity Global Tech., 2016 Tex. App. LEXIS 8795, 90 U.C.C. Rep. Serv. 2d (Callaghan) 533 (Tex. App. Dallas 2016).

At what point does a court cross the line from insuring “a fair quantum of remedy” to improperly rewriting a contract to correct a bad deal made by one of the parties? The line is not always distinct. In the CGBM case, the court held that the limited remedy provided on the face of the contract “would deprive Plaintiffs of the substantial value of their bargain with Flowserve.”

The court cited in support of its holding E.F. Johnson Co. v. Infinity Global Tech., 2016 Tex. App. LEXIS 8795, 90 U.C.C. Rep. Serv.2d (Callaghan) 533 (Tex. App. Dallas 2016). In that case, EFJ acted as exclusive distributor of Infinity’s GPS-Mic and made an “irrevocable and non-cancellable” promise to take and pay for a minimum purchase of the GPS-Mic over three years. After just one year, EFJ terminated the agreement and refused to take or pay for any more units. Infinity and a co-defendant sued EFJ, and a jury awarded damages against EFJ in excess of $2.5 million, plus attorney’s fees. On appeal, EFJ argued that the damages should have been capped at the total amount EFJ paid Infinity at the time of the termination—$49,600—in accordance with the limitation-of liability provision of the parties’ contract. The court rejected that argument, holding that limiting EFJ’s damages would deprive Infinity of the substantial value of its bargain and would not provide it a “fair quantum of remedy.” The limitation-of-liability provision was unreasonable, and thus unenforceable.

Practice Tips and Lessons of CGBM

Without opining on the correctness of the CGBM court’s decision, the case offers valuable lessons on matters that come up with regularity in drafting contracts.

  • A client cannot give and disclaim an express warranty. A purported disclaimer of “all other warranties, express or implied” in the contract cannot undo a bona fide express warranty. If the client makes assurances about a product’s capabilities and the other party relies on them, the client should not expect the written contract to save it from all responsibility it if it fails to live up to the assurances.
  • The client needs to be cautioned about making promises outside the written contract. Any promises about the product should be carefully worded and included in the document so that there is no dispute about them.

The client also needs to understand that promises he or she makes after contract formation may be relatively easy to enforce since merger and non-reliance clauses are not a bar to post-formation communications. See, e.g., U.C.C. § 2-313, Comment 7 (post formation warranties may become modifications of the contract).

  • If the client insists on having a very limited repair or replace remedy, it needs to be prepared to deliver on its promises—if it doesn’t, it risks losing all the other protections in the contract designed to limit its liability.
  • Even if the seller promises to return the buyer’s money in the event of a breach, that may not be a legally sufficient remedy to make the buyer whole if the buyer incurs all manner of additional foreseeable expense due to the breach.
  • The overarching and most daunting lesson of all: the written contract is not an impenetrable fortress that can whitewash the client’s responsibility from the consequence of its actions. Fairness is sometimes a force more potent even than freedom of contract.

Timothy Murray is the coauthor of the Corbin on Contracts Desk Edition (2017) and the biannual supplements to Corbin on Contracts. He practices law as a partner in Murray, Hogue & Lannis in Pittsburgh, Pennsylvania, where he has represented all manner of clients in business disputes and transactional matters.

To find this article in Lexis Practice Advisor, follow this research path:

RESEARCH PATH: Corporate Counsel > Contract Formation > Contract Clauses > Articles > Disclaimers of Warranty

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1. The facts recited here are those considered in connecton with the defendant’s moton for summary judgment, which means they are construed in the light most favorable to the plaintffs, the nonmovant. 2. E.g., Jacobson v. Hofgard, 2016 U.S. Dist. LEXIS 26802 (D.D.C. 2016): “. . . the mere presence of an integraton clause does not automatcally preclude claims premised on representatons or omissions that fall outside the contract.” Integraton clauses should not be used to play a game of “gotcha,” the court wrote. 3. Billington v. Ginn-LA Pine Island, Ltd., LLLP, 2016 Fla. App. LEXIS 7718, 41 Fla. L. Weekly D 1204 (2016). 4. In additon, many, but by no means all, jurisdictons hold that when a limited remedy fails of its essental purpose, if the contract also contains an exclusion of consequental and incidental damages (as this one does), that exclusion remains valid. See, e.g., Corbin on Contracts Desk Editon § 29.04 (2017). The court did not deal with this conundrum.