Contracts are generally entered into with performance in mind, not breach. For that reason, parties seldom consider the damages that may be awarded in the event of breach, except with respect to the definition of and caps on the losses recoverable for breach of representations and warranties pursuant to the indemnification provisions of acquisition agreements. In contract law, as opposed to tort law, damages for breach of contract are normally constrained by common-law rules designed to compensate the non-breaching party for the nonperformance of the breaching party, rather than to punish the breaching party. In other words, breach of contract damages are generally limited to the amount necessary to replace the non-breaching party’s loss resulting from the contract’s non-performance by the breaching party, what courts call the non-breaching party’s “expectation interest.” And as a general rule, “no matter how reprehensible the breach, damages that are punitive, in the sense of being in excess of those required to compensate the injured party for lost expectation, are not ordinarily awarded for breach of contract.” This rule has been said to “add to the celebrated freedom to make contracts, a considerable freedom to breach them as well.”
While the rule denying the award of “punitive” or “exemplary” damages for breach of contract is subject to certain limited exceptions, it appears to enjoy wide-spread acceptance in most states and in virtually all common-law countries. But one of the well-recognized exceptions that can sometimes threaten to swallow the rule is that which permits punitive or exemplary damages anytime “the conduct constituting the breach is also a tort for which punitive damages are recoverable.” And a “dog’s breakfast” of tort-based fraud claims can frequently accompany a breach of contract claim.
Fraud claims have “proven to be tough to define, easy to allege, hard to dismiss on a pre-discovery motion, difficult to disprove without expensive and lengthy litigation, and highly susceptible to the erroneous conclusions of judges and juries.” As a result, the private company acquisition market has moved toward defining fraud (for the purpose of a carve-out to the contractual cap on indemnification) so that it is limited to the conveyance of knowing falsehoods in the written representations and warranties set forth in the acquisition agreement, with all other forms of fraud and sources of purported representations being disclaimed. The purpose behind these prophylactic provisions is to limit the circumstances in which the contractually-limited liability caps may be ignored to a defined and particularly egregious type of fraud (and one with respect to which the law appears to be disinclined to allow contractual disclaimer in any event). But not all private equity sellers follow this market movement toward defining fraud carve-outs from the indemnification caps. And even when fraud is defined in a limited manner, what constraints remain once the caps are removed based on a finding of fraud, justified or not? In other words, can a contract, notwithstanding a tort-based claim of fraud, nevertheless constrain the ability of a buyer to recover exemplary or punitive damages beyond the ordinary limitations on contract-based damages recoveries?
Recently, the Texas Supreme Court answered this question in the affirmative. In Bombardier Aerospace Corp. v. SPEP Aircraft Holdings, LLC, No. 17-0578, 2019 WL 406075 (Tex. Feb. 1, 2019), the buyer sued the seller of an airplane for breach of contract and fraud related to allegations that the airplane’s engines had been previously installed on other aircraft before being installed on what was otherwise supposed to be a new airplane. At trial, the buyer successfully obtained a finding that the seller had both breached the contract and engaged in fraud. Because punitive damages were available for the fraud claim, but not the breach of contract claim, the buyer elected to recover on its fraud claim, not its breach of contract claim. Actual damages, primarily for diminution in value, were awarded in the amount of $2,694,160, and punitive damages were awarded in the amount of $5,388,320 (basically two times the actual damages). The seller appealed on a variety of matters. But for our purposes the relevant issue was a provision contained in certain agreements signed by the buyer regarding the aircraft’s purchase from, and management by, the seller. While the provision differed slightly in each agreement, the clearest provision stated: “Neither party hereto may be held liable to the other party for any … punitive damages for any reason.”
The intermediate appellate court held that the above referenced provisions were invalid insofar as they purported to limit the damages recoverable for fraud. The Texas Supreme Court, relying on Texas’ “strongly embedded public policy favoring freedom of contract,” however, upheld the liability-limiting provisions waiving punitive damages, even for fraud. According to the court, “[a}lthough [seller’s] conduct in failing to provide [buyer] with the new engines [buyer] bargained for was reprehensible, the parties bargained to limit punitive damages, and we must hold them to that bargain.” The court acknowledged that such a clause would not have been valid to the extent it related to a consumer-oriented statutory grant of treble damages for deceptive trade practices, or to a provision purporting to relieve a party from liability for personal injury as a result of a party’s gross negligence. But a waiver of punitive damages, even in the face of a fraud claim, did not violate public policy when it still permitted collection of actual damages.
Because punitive damages are generally not available for breach of contract, some have speculated as to the purpose of excluding “punitive damages” as recoverable losses in private company acquisition agreements. This case may well provide a potential answer. However, this is just one state’s view. The law in other states is not all that clear. But it certainly can’t hurt to add a prophylactic waiver of punitive damages just in case you become the subject of an unjustified fraud claim in a court where fraud claims arising from a contract are potentially subject to a punitive damages award, but contractual waivers of such an award are nonetheless permitted. If you happen to be in the Delaware Court of Chancery, of course, punitive damages are not permitted to be awarded in any case (except as prescribed by statutory authority) due to the limited jurisdiction of the Delaware Chancery Court (something to keep in mind in selecting venue).