Incentive-ize, Don’t Penalize with Liquidated Damages Clauses for Contract Breaches

Contracts are designed to provide insurance, predictability, and sometimes consequences for a party’s failure to perform its obligations. Those consequences are usually called “damages” and are monetary awards usually for the value of the lost product, service, or other items contracted for. The problem is that the courts are where the scope of damages are fleshed out and these battles are often as dirty and ugly as the battle over whether a party breached in the first place. Without a clause that sets forth the value of damages outright, a contract for services is nearly useless in an era where the value services are increasingly difficult to pin down.

Enter the “liquidated damages” clause. Contrary to what its name suggests, it provides a reasonable pre-determined damages award, adding greater insurance, predictability, clarity, and above all deterrence value to a contract. Such clauses can guard against delay in performance, outright failure to perform, and a variety of other breach scenarios. Moreover, the value of the damages clause does not have to be an accurate portrait of what “actual” damages would be upon breach. They need to be a reasonable approximation of harm suffered, they need to be specific and/or set out a specific formula, and they should not seek to penalize the breaching party.

Take the issue of the early termination of a services contract whereby the non-breaching party would lose revenue from its accounts due to the breach. “Y shall pay X per each of X’s customers, thirty percent (30%) of that customer’s highest monthly usage commission fee during X’s past fiscal quarter multiplied by a factor of six.” This clause provides a specific formula that is patently not a penalty. The goals of the clause are satisfied in that it provides clear relief coupled with deterrence value. Without such a clause, actual damages (i.e. the actual extent of pecuniary harm suffered by the non breaching party would have to be proven), which itself can prove costly in terms time and money.

Drafting Considerations for a Liquidated Damages Clause:


• Any liquidated damages clause should reflect an understanding of the types of harm one can suffer in a particular scenario, relationship, and industry. The clause should appear to be a mechanism that attempts o place the non breaching party in the position that they would be in had a breach never occurred, though as mentioned, the clause does not have to be absolutely precise or accurate;
• The ultimate formula or amount should be an approximation of the actual harm the basis of which can be rationally articulated—in other words, don’t pick something out of a hat;
• Do not use a clause that is punitive and leads someone to believe that you are making it impossible to breach without suffering a penalty above and beyond what the breach costs.
• Some contracts specifically mention that the parties have considered the provisions and warrant that it does not constitute a penalty. This language helps but does not automatically insulate the clause from being deemed a penalty by a court.

To reiterate the above, a special caveat to the businessperson: A liquidated damages clause that appears to be a penalty provision will not get the court’s blessing. Such a clause will not be enforced and the very uncertainty it was designed to guard against will befall the parties. Penalty clauses are inherently disproportional to the scope, nature, and character of the potential harm caused by a breach. Examples include a clause that imposes one million dollars in damages for the failure to deliver a 15 inch television to a family home on time, or a clause that imposes one million dollars for a single day’s delay in delivering that same television.

Kaiser Wahab

Say Hello to My Little Console

Continuing the trend of top notch stars re-breathing life into the video game industry's flirtation with live actors, Al Pacino has inked a deal with Vivendi to voice a video game version of "Scarface." Again, the Hollywwod console trend becomes apparent with other games to feature deceased Marlon Brando and still among us Clint Eastwood.

Death and Taxes Deadlines Certain—SOX Stock Option Accounting Deadline Not

The tech industry has scored a halftime victory by convincing the SEC to at least provide a six month extension to the controversial stock option accounting rule imposed by Sarbanes Oxley (“SOX”). Under that rule, public companies must report stock options as a company expense as opposed to a footnote. Understandably this will drastically alter the valuation of many companies. Tech companies are extremely stock option driven and have traditionally used them to lure and retain top minds for bottom dollar in a cash burn environment.

Although the extension is generally welcome it does not come without its catches as with anything from the government. The extension is linked to a corporation’s fiscal year. Hence, some companies, including heavyweight Cisco, have already begun the arduous task of tracking their options through in house and outsourced means.

Despite the bitter fight over the character of the new rules developed by the Financial Accounting Standards Board, this is the second time the rules’ implementation has been delayed. The board, overseen by the SEC, originally intended to implement the changes on a fiscal year basis for fiscal years commencing after Jan. 15. Under the SEC’s supervision, the board instead delayed the implementation of the rules applying them to any fiscal quarter or year that started after June 15.

The SEC while not abandoning its expense approach for stock options may have unwittingly given the tech company lobbyists flanking room to get the rules nixed. This is still very much a live debate. Given other SOX rules’ and their implementation are still being evaluated under a Republican controlled govermnent, the general mood on the hill may favor a less politically painful rollback of rules that have yet to be implemented.

Kaiser Wahab

XBOX on MTV's Top 40

Let no one get the impression that video games are the opiate of the unwashed basement dwelling geek hordes. It is the stuff of prime time and apparently now MTV. Microsoft intends to take its new XBOX to the pop culture organ for its debut. Certainly this is a clear sign of the gaming industry trends and times, in terms of the sophistication of the advertising and licensing practices that game attorneys will have to address. As I mentioned before, the more you look at it, the more you see the convergence of two venerable but previously separate legal practices—film and software technology. A skilled practitioner will have to manage any gaming platform, application, accessory, and/or promotion, in the context of an industry that is drawing on the same talent and resources as Hollywood, with delivery channels light years ahead of Hollywood.

Kaiser Wahab

The barred Kingdom of Spam-a-Lot—Historic 9 year Jail Sentence Sent to Jeremy D. Jayne’s Inbox for First Spam Felony Conviction

Just as the pundits debate the impact of anti spam legislation on the torrent of messages for everything from penis enlargement to graduate degrees from the University of Bratislava, a historic jail sentence is sure to give all players a moment of pause. Jeremy Jaynes, aka Gaven Stubberfield, who at one point made a staggering $750,000 per month will now be serving the first felony sentence ever for spamming AOL users under the Virginia anti spam law which closely parallels the federal CAN-Spam. Although a resident of North Carolina, Jaynes was convicted in Virginia under the law, because among others, he targeted AOL users Act. See long arm statute here. AOL maintains servers in its Virginia headquarters. Jaynes has the dubious distinction of being a spam superstar and at the time of his arrest last December, Jaynes was listed as the eighth most prolific spammer by Spamhaus.org.

Although I am no fan of Spam (and really, who is a “fan”?), I do question the proportionality of the sentence. Jail time is sufficient to demonstrate that spam is indeed an offense that carries stigma and real repercussions. However, Jayne's attorney, David Oblon, was quoted by the Associated Press as stating, "Nine years is absolutely outrageous when you look at what we do to people convicted of crimes like robbery and rape." Unfortunately, I have to agree. Despite the millions of dollars and man-hours lost at the hands of spammers, one has to question if the court and the jury were a little too heavy handed with this sentence. I do not doubt that the sentence will have an impact, I only hope that Jaynes is not the sacrificial lamb.

Kaiser Wahab

Open Season on Open Source--The New Open Source Paradigm

As the popularity of Linux in database and research application environments becomes harder to deny, soon its popularity in the general computing environment will be impossible to dismiss. The robustness, cost advantages, and communal aspects of open source applications is becoming the rage on hard drives across the nation. And startups to established giants rely on open source technology. However, as the euphoria is leading to bigger market share gains, the risks from potentially hazardous and uncertain open source licenses is a topic for concern.

Open source infringement appears to be oxymoronic, but the combination is real. Potential open source infringement only became a public issue when the SCO Group sued IBM, for allegedly infringing several thousand lines of SCO code in the IBM’s Linux kernel and later that complaint was expanded to include damages of five billion dollars. Notably, SCO did not stop at IBM’s door, it sent cease and desist letters to Fortune 500 known users of Linux as well, including Daimler Chrysler. The implications of this action are clear. If you are unknowingly incorporating code in the crosshairs of an infringement suit, you may be liable as an end user or developer.

As tragedy begets opportunity, several new niche products and services have merged. For example, there is open source insurance which is deigned to protect an enterprise from the SCO IBM scenario. And now, there are also software solutions designed to scour code for potentially infringing code. In the end however, these two items cannot replace simple due diligence and strategic planning. In other words, as the open source community increasingly becomes commercial, the same licensing headaches that have been wrongly derided as the playground of big bad capitalist behemoths will find their way into the open source arena.

Our last blog entry was about the real care that startups should take in incorporating open source materials into their product offerings. And the array of open source licenses should not be considered an excuse to waste ink. They impose very significant and often unclear constraints on and end user’s ability to create derivative applications and any pass through liability or warranties. More often startups confuse the availability of open source components with real measures of open source’s value—collaboration, development speed, user cost efficiencies, etc. However, if the startup’s business model is something more traditional and proprietary like Microsoft, then open source should not be taken for granted as some sort of low cost stepping stone. Accordingly, Redhat is a service company for a reason.

Kaiser Wahab

Using Open Source Could Shut Doors--Use of Open Source Code by Start-Ups

In an effort to speed product to the market, many start-ups have taken to integrating their proprietary software with that of open source software already in the marketplace which has proven stable and effective. This approach potentially presents a variety of legal obstacles, the most substantial being that the company will effectively convert its own product into open-source software that must be licensed for free.

Open source software is licensed in a variety of ways. Most licenses require that all licensees permit free redistribution of the original open source code. Others, however, are more restrictive. They demand that even open source software that is substantially modified, must be re-licensed be free of charge. Other open source software licenses are silent as to whether the software, even when modified, must be redistributed free of charge. In determining whether an alteration of open source software is a “mere modification’ requiring that the re-license be free of charge, or a fundamentally new development that is subject intellectual property protection, the company’s engineers should review with counsel exactly how the open source code will be used.

If a determination is made that the company’s proprietary code will be tainted by its integration with open source code, the company should take all of the following measures to protect its intellectual property rights:

• Take all programming steps necessary to maintain the open source program’s separate identity in the way it is engineered into the proprietary product.
• Provide specific instructions, including website addresses, in order that anyone can obtain the original open source code without the need to reverse engineer the proprietary product.
• Maintain the open source program’s separate identity in the way the program is described in documentation and license agreements, and in the way the copyright notice is displayed.
• Impose appropriate restrictions on the use and redistribution of the open source program that is consistent with its original license, and prohibit reverse engineering of its binary code.

Simon Riveles