Hindsight is not 20/20 when Interpreting Liquidated Damages Clauses in Public Contracts

Liquidated Damages Provisions Generally

Typically, courts in Ohio (and elsewhere) follow a well-known principle of interpreting contract language so as to carry out the intent of the parties, when that intent is evidenced by clear, contract language. This is especially true in commercial settings where courts deem each party on equal footing, able to secure counsel and able to understand sophisticated business principles. In other words, courts will generally uphold language in commercial contracts, unless contrary to statutory law or public policy. Consequently, commercial parties have a lot of leeway in allocating the risk of a particular deal. One way parties to a contract allocate risk is to insert a “liquidated damages” provision into a contract.

“Simply stated, liquidated damages are damages that the parties to a contract agree upon, or stipulate to, as the actual damages that will result from a future breach of the contract. The effect of a clause for stipulated damages in a contract is to substitute the amount agreed upon as liquidated damages for the actual damages resulting from breach of the contract, and thereby prevent a controversy between the parties as to the amount of damages.” The law in Ohio and elsewhere regarding liquidated damages provisions in real estate and construction contracts is that when they are fair and reasonable attempts to fix just compensation for anticipated loss caused by breach of contract, they are enforced; alternatively, when they are penalties, or punishments for default, they are not enforced. The difficult problem, in each case, is to determine whether or not the stipulated sum is an unenforceable penalty or an enforceable provision for liquidated damages.               

Enforceable Liquidated Damages Provision or Unenforceable Penalty-The 3 Part Test

 To help provide guidance, the Supreme Court of Ohio in Samson Sales, 12 Ohio St.3d at 28, 465 N.E.2d 392 set forth a three-part test to determine whether a contractual provision should be considered an enforceable liquidated-damages provision or an unenforceable penalty. The court held: “Where the parties have agreed on the amount of damages, ascertained by estimation and adjustment, and have expressed this agreement in clear and unambiguous terms, the amount so fixed should be treated as liquidated damages and not as a penalty, if the damages would be (1) uncertain as to amount and difficult of proof, and if (2) the contract as a whole is not so manifestly unconscionable, unreasonable, and disproportionate in amount as to justify the conclusion that it does not express the true intention of the parties, and if (3) the contract is consistent with the conclusion that it was the intention of the parties that damages in the amount stated should follow the breach thereof. For example, a clearly written provision in a $300,000 construction contract between private parties calling for liquidated damages of $150,000 for not completing the building on time would probably be held as a penalty because the penalty is unfairly disproportionate to the amount of the contract.

What about Liquidated Damages Provisions in Public-Works-Construction Contracts? (Boone Coleman Constr., Inc. v. Piketon, Slip Opinion No. 2016-Ohio-628)

Should public contracts be interpreted any different? Should the “Samson Test” be applied in public as well as private contracts? What if a seemingly fair liquidated damages provision of $700/day for each day late (measured at the beginning of a contract) seems not so fair when measured at the end of the contract because of a 365 day delay? Would that be a penalty or a fair measure of liquidated damages? These were the issues recently faced by the Ohio Supreme Court in “Boone”.

The facts of the case seem simple and straight forward. In 2007, appellant, the Village of Piketon, solicited bids for the “Pike Hill Roadway and Related Improvements” project (for the installation of a traffic light and roadway improvements at the intersection of U.S. Route 23 and Market Street in Piketon).  Appellee, Boone Coleman Construction, Inc. submitted the lowest bid and was hired for the project. The parties entered into a contract in which Piketon agreed to pay Boone Coleman $683,300 to complete the work. The contract expressly provided that the time was “of the essence” with regard to completion of the project. A liquidated-damages clause provided that Boone Coleman would pay $700 to Piketon for each day after the specified completion date (120 days after contract signing) that the contract was not substantially completed. The contract provided, in pertinent part: “OWNER and CONTRACTOR agree that as liquidated damages for delay (but not as a penalty), CONTRACTOR shall pay OWNER $700.00 for each day that expires after the time specified in paragraph 4.02 for Substantial Completion until the Work is substantially complete”.

Boone Coleman did not complete the project until July 2, 2009― over a year after the parties’ extended the completion date. Boone Coleman brought suit against Piketon in the Pike County Common Pleas Court, alleging, among other things that Piketon had improperly failed to pay $147,477 of the contract price for the construction. Piketon counterclaimed for liquidated damages. The trial court granted Piketon’s motion for summary judgment, awarding Piketon $277,900 in liquidated damages. Boone Coleman appealed, asserting that the trial court erred in awarding Piketon liquidated damages. The appellate court agreed. They applied the Samson Test but found the $277,900 in liquidated damages was clearly disproportionate to the $683,000 contract price. Piketon then appealed to the Ohio Supreme Court who overruled the appellate court and upheld the applicable provision for liquidated damages of $700 per day for delay of completion.

The Ohio Supreme Court also applied the Samson Test in Boone and agreed that the appellate court properly applied the first and third parts of the test. The appellate court properly recognized that “the damages incurred as a result of a delay [by Boone Coleman in completing the project] were uncertain as to amount and difficult to prove” and that “the plain and unambiguous language of the liquidated damages clause is consistent with the conclusion that the parties intended that damages in the amount of $700 per day would follow the contractor’s breach of the project completion deadline.”

The Supreme Court of Ohio, however, disagreed that the 2^nd prong of the Samson Test (regarding disparity between the liquidated damages and contract amount) was properly applied by the appellate court. According to the Ohio Supreme Court, “The correct analysis looks at whether it was conscionable to assess $700 per day in liquidated damages for each day that the contract was not completed, rather than looking at the aggregate amount of the damages awarded [after the fact].” In other words, the Ohio Supreme Court directs us to look at the per diem damage amount, prospectively, rather than the total sum, after the fact (which the appellate court focused on).

Also important to the court in Boone overturning the appellate court’s decision is the nature of public vs. private construction contracts. Every Ohio-funded public-improvement construction contract, for example is required by the Ohio Revised Code to include a liquidated-damages provision. (See O.R.C. Section 153.19). In other words, liquidated damages provisions in public contracts are seemingly more appropriate because they are sanctioned by the Ohio General Assembly. Moreover, the Ohio Supreme Court recognized that contractors in public works contracts need to answer to a “higher authority”; the public. As stated by the Supreme Court in Boone, “We recognize that liquidated-damages provisions in public construction projects play an important civic purpose in that they help foster timely completion of the project, thereby avoiding the loss of billions of taxpayers’ dollars caused by contractors’ delays.” In other words, (according to the court), “the protection of the public interest is a proper consideration in determining [the] validity of a liquidated damages provision.”

Finally, important to the court’s holding was the fact that the liquidated damages clause in Boone was a per diem amount vs. a lump sum, and “in failing to recognize this distinction, the appellate court committed its second error.” Citing precedent, the Ohio Supreme Court in Boone stated, “[T]he agreement to pay a specified sum weekly during the failure of the party to perform the work, partakes much more of the character of liquidated damages than the reservation of a sum in gross.”

What is the moral of this story? To quote Benjamin Franklin (as cited by the court), “Time is Money.” In other words, caveat public contractor. Watch your language with liquidated damages clauses in public works contracts. Reasonable, per diem liquidated damages set at the outset are likely to be enforceable, even if they total, at the end, a disproportionate amount to the original contract price.

"Spear Phishing": An Increasing Threat to Real Estate Transactions

All parties involved in real estate transactions need to take care in how they handle the closings and wire funds.  Reports in both the United States and Britain show in increase in what is known as “spear phishing”.

An article by Rose Meily published in the San Jose Mercury News states, “Small real estate businesses, agents and their clients are increasingly becoming targets of sophisticated cyber scammers, according to panelists at a risk management forum at the 2015 National Association of Realtors Conference & Expo held last month in San Diego.”

The article goes on to quote Jessica Edgerton, associate counsel to the National Association of Realtors, stating that “real estate professionals have reported an upswing in spear phishing, a particular wire scam where a hacker breaks into an agent's email account and obtains information about an upcoming real estate transaction. After monitoring the account, the hacker will send a mock email to the buyer as they near closing, posing as the agent or someone from the title company and requesting that the buyer wire transaction-related funds.”

A recent article in the Telegraph highlights a similar trend in Britain, and indicates the problem is “escalating, with latest figures showing fraudsters carrying out two successful conveyancing frauds a week, earning them in the region of £250,000 [$162,360.81] a week.”

One method used by fraudsters is malware that accesses the computers of individual buyers and sellers, as well as those of the real estate agents, title companies and law firms.  Public Wi-Fi and poorly protected Wi-Fi systems are also fertile ground for accessing people’s emails.  From there, a hacker can sift through the emails until information is found about a pending real estate closing.  With the information gleaned through the emails, a hacker can then spoof the email of the seller or other appropriate party to communicate a ‘change’ in the wire instructions so funds are diverted into the criminal's account.

One practice that can prevent a criminal diversion of funds is to always confirm by phone any emailed requests for changes to wire instructions. Parties also need to avoid using public Wi-Fi networks with their mobile devices when real estate and other transactions are pending that involve the wiring of closing funds.

With the increase in spear phishing, all parties to a real estate transaction needs to up their game to avoid become the victim or unwitting conduit to cyber fraud.
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IF THE FORM DOES NOT FIT, YOU MUST ALTER IT (#4)

There are many different types of purchase/sale agreement forms in use, varying in type, complexity and standardization. Real estate broker or legal stationary company “standard” forms, for example are used in most residential deals. The inherent problem with the “standard form”, however is that there is little that is standard about a real estate transaction. Every purchase/sale is unique because there are different types of property, different buyers and sellers (with different levels of motivation and sophistication) and different potential liability in each transaction. In commercial transactions, standard forms can rarely be relied upon, since the commercial transaction usually involves more dollars and more complexities. Custom made forms by a law firm are the norm for commercial transactions which forms typically include representations and warranties, covenants, multiple contingencies and extensive diligence periods. Occasionally, a party to a “simple” commercial deal will be presented with a broker form contract designed more for residential than commercial transactions.

The real estate attorney’s optimal role can be analogized to that of a department store tailor. Sometimes, parties cannot afford custom made suits (“contracts”) from an expensive boutique “store”. On the other hand, the off the rack suit at a department store (“standard form”) rarely fits all body types (“transactions”). Consequently, If the off the rack suit (“form”) does not fit, you must alter it.  Inapplicable clauses of a contract can be crossed out and initialed by the parties on the form. Small insertions can be written in and initialed, and large insertions can be added by way of addendum. Please note that brokers crossing out contract provisions and drafting new language may be crossing the line into the “unauthorized practice of law.” Contract modification is best effected with advice of counsel.

 We recently had occasion to tailor a residential broker form for the purchase of a small commercial building to be used as a restaurant.  While a new, custom made agreement was initially advised (and actually, would not have been more costly for our client), the Seller was insisting we use his broker’s “standard form” and our client did not want to lose the deal. So, we got out our “needle and thread” and went to work. After crossing out inapplicable provisions such as home warranties and Ohio Residential Disclosure Form disclosures, we found the following major provisions conspicuously absent, most of which are not found in standard, off the rack forms, and incorporated them into a short addendum. (Of course, each transaction is different, and we are not advising the following are appropriate or comprehensive enough for every transaction).

1.         Due Diligence.  There are various inspections in the residential form (e.g. pest, septic) but no mention of surveys, environmental audits and other reviews typically recommended in a commercial transaction. Buyers in such a situation may want to consider a provision comparable to the following, sometimes referred to as a “free look”:

“Buyer shall have a period of sixty (60) days (the “Due Diligence Period”) from the latest date the mutually signed Agreement and this Addendum were signed by a party hereto (the “Effective Date”) to inspect the Property and to perform such investigations, environmental audits, review of title, zoning and survey and otherwise engage in such inspections and investigations as desired by the Buyer.  Seller agrees to cooperate with Buyer to allow Buyer and its agents to enter the Property for such inspections and investigations and to assist (without expense to Seller) in obtaining information requested by Buyer.  Should Buyer determine that the Property is not suitable for any or no reason in Buyer’s sole and absolute discretion, Buyer may terminate the Agreement by providing written notice thereof to Seller no later than the last day of the Due Diligence Period.  Upon such termination, all earnest money deposits plus interest earned thereon will be promptly returned to Buyer (without further action of the parties), and the parties will have no further obligations hereunder.  Should Buyer fail to timely terminate the Agreement as described above, Buyer shall no longer have the right to terminate the Agreement under this provision.  The inspections set forth in this Paragraph 1 are in addition to, and not in lieu of, the other inspections of Buyer under the Agreement, and in the event of conflict (between any provisions of the Agreement and this Addendum concerning timing, rights of the parties and otherwise re: inspections), this Addendum shall control.

            2.         Warranties.      Seller represents and warrants to Buyer as of the Effective Date and as of the Closing Date, as follows:

a)  No party other than Buyer has any claim to the Property by reason of any purchase agreement, option to purchase, right of first refusal, land installment contract, lease or other similar agreement or instrument;

b) There are no suits, actions or proceedings pending or, to Seller’s knowledge, threatened against or concerning any of the Property, or against Seller with regard to the Property;

c) There are no encroachments and there are no boundary disputes with owners or tenants of adjacent properties;

d) The Property complies with all applicable zoning, building, health, safety, environmental, and all other applicable laws, ordinances and regulations (collectively “Legal Requirements”). Seller has not received notice from any governmental authority advising or alleging that the Property is in violation of any such Legal Requirements; and

e)   No Hazardous Substances  (as defined by the Legal Requirements) have been used, generated, released, spilled, leaked, stored, or disposed of beneath, on or at the Property by Seller (or to Seller’s knowledge, by any predecessor in interest or any other person).

3.         Covenants. Between the Effective Date and the Closing Date, Seller agrees that: a) it will manage and operate the Property in compliance with the Legal Requirements and maintain the Property in good working condition (including making all customary and necessary repairs and replacements to the Property), ordinary wear and tear excepted; and b) it will not create any lien, encumbrance, easement, covenant or restriction upon the Property or voluntarily take or permit any action adversely affecting the title to the Property as it exists on the Effective Date of this Agreement, without Purchaser’s consent.

                       

            4.         Conditions.      Anything herein contained to the contrary notwithstanding, the obligations of Buyer under this Agreement are subject to and conditioned upon the following, unless waived in writing by Buyer: (a)  All of the representations and warranties set forth herein shall be true and correct as of Closing; (b) the Agreement shall not have been terminated pursuant to any right to terminate granted to a party under the Agreement; (c)  the Title Company shall be in a position to issue the Title Policy to the Buyer as required in Section __ of the Agreement; (d) there shall have been no material adverse change in the condition of the Property; (e) the Seller shall have delivered all items required by this Agreement to be delivered by it; and (f) the Seller shall have complied, in all material respects with Seller’s covenants prior to Closing, in accordance with Section 3 of this Addendum II. In the event any of the above conditions is not satisfied by the Closing Date, Buyer may terminate this Agreement by written notice given to Seller on the Closing date.  In the event of such termination, the Earnest Money and all funds and documents deposited by Buyer shall be returned to Buyer and thereupon the parties shall be fully released from any further obligations to the other under this Agreement

While form is important, don’t forget that “timing is everything”. Consult an attorney before the purchase agreement is signed. The disgruntled suit buyer can insist that the seller re-alter or accept the return of an ill-fitted suit. The disgruntled property buyer (or seller) however, has no legal grounds to insist that the other party accept changes to the contract after it is signed.

New Survey Standards Take Effect On February 23, 2016

New ALTA/NSPS (fka AlTA/ACSM)*standards were adopted and take effect on this month on February 23^rd.  The new standards replace ALTA/ACSM standards previously adopted in 2011.

Below is a link to a redline of the changes in the new 2016 survey standards compared to the 2011 standards:

http://www.nsps.us.com/resource/resmgr/ALTA_Standards/2016_Standards_REDLINE_20151.pdf

 

* The National Society of Professional Surveyors (NSPS) is the successor entity to the American Congress on Surveying and Mapping (ACSM).

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Bankruptcy Sale of Thistledown Racetrack Held not an “Arms-Length” Transaction

The “general rule with regard to determining value of real property (in order to calculate real estate taxes) is that the purchase price at a recent (within 3 years) “arms length sale” of the property between a willing buyer and willing seller is dispositive.  What better indication of value than the price someone is willing to pay and actually pays for the property? Of course, there are exceptions to every rule, but the recent decision of the Supreme Court of Ohio in Warrensville Hts. City School Dist. Bd. of Edn. v. Cuyahoga Cty. Bd. of Revision, Slip Opinion No. 2016-Ohio-78 is more clarification than exception.

In Warrensville Hts., the Board of Education of Warrensville Heights City School District (“Board of Education”) appealed from a decision of the Board of Tax Appeals (“BTA”) finding the tax year 2010 value of Thistledown Racetrack in Cuyahoga County to be $13,800,000, not the $43,000,000 purchase price at a bankruptcy sale six months after the tax-lien date. According to the BTA (affirmed by the Ohio Supreme Court), “sales conducted under supervision of a court order are forced sales which are not indicative of true value.”

 The facts of this case are simple enough (the ruling, not so much, in spite of first impressions). The subject property is Thistledown Racetrack, a thoroughbred-racing facility on 128 acres of land, located in Cuyahoga County, aka the home of the Ohio Derby. In 2009, the owner of the property petitioned for Chapter 11 bankruptcy relief and received authority to sell the racetrack at auction. Harrah’s Ohio Acquisition Company, L.L.C. (“Harrah’s), submitted the best and highest offer, however, a condition to the sale did not occur, which prompted a second auction. At the second auction (in 2010), Harrah’s again submitted the winning bid to purchase Thistledown. The contract basically stated that in exchange for $43,000,000, Harrah’s would assume ownership of the real property as well as equipment, intellectual property and other items. The sale was contingent on Harrah’s ability to obtain Thistledown’s racing license from the racing commission (which would also enable Harrah’s to operate lucrative video lottery terminals). The bankruptcy court approved the sale and Harrah’s filed the deed in July, 2010, after it received the racing license.

For tax year 2010, the Cuyahoga County Fiscal Officer assigned a total value of $14,264,000 to Thistledown. The Board of Education filed a complaint with the board of revision (“BOR”), seeking an increase to the purchase price established at the first auction: $89,500,000. The property owner requested a reduction to $5,500,000, claiming most of the value was attributable to the personal property and racing license, not the real estate. The BOR retained the fiscal officer’s initial valuation of $14,264,000.

The Board of Education appealed to the BTA, requesting an increase to $43,000,000, the price Harrah’s paid for the property at the second auction, and Harrah’s requested a decrease to $13,800,000. The school board relied on the 2010 sale, arguing that the $43,000,000 sale price reflected the value of the real property. The property owner reiterated her prior testimony that the sale price reflected the purchase of other assets in addition to real property.

The BTA agreed with Harrah’s valuation of $13,800,000. The BTA rejected the 2010 sale price as evidence of value, explaining that “[a]lthough it is clear that the subject property sold recent to [the] tax lien date, we do not find the sale to have been arm’s-length because it was subject to the approval of a bankruptcy court.”

The Board of Education appealed to the Ohio Supreme Court and the court affirmed the BTA’s decision.

In its analysis, the Ohio Supreme Court first looked at the applicable statute to reiterate the “general rule” at the time:

“During the tax year at issue, former R.C. 5713.03 sets forth how real estate is to be valued for tax purposes: ‘In determining the true value of any tract, lot, or parcel of real estate under this section, if such tract, lot, or parcel has been the subject of an arm’s length sale between a willing seller and a willing buyer within a reasonable length of time, either before or after the tax lien date, the auditor shall consider the sale price of such tract, lot, or parcel to be the true value for taxation purposes’.”  (Note: Pursuant to Ohio Am. Sub H.B. 487 (H.B. 487) signed into law on June 11, 2012, the revised statutory language of R.C. 5713.03 now provides that an auditor "may" (vs. shall) consider the price of a recent sale as value.)

The court then summarized R.C. 5713.04 (“[t]he price for which such real property would sell at auction or forced sale shall not be taken as the criterion of its value”)

and concluded that, “the BTA reasonably and lawfully determined that the sale price did not establish the property’s true value for two reasons…First, Thistledown Racetrack sold at auction [and]… Second, reliable and probative evidence in the record supports the finding that Thistledown sold at a forced sale within the meaning of R.C. 5713.04.”

At first glance, it appears that the court is establishing R.C. 5713.04 as a clear exception to R.C. 5713.03; however, upon further review, as well as a quick read of the decision of the Ohio Supreme Court in Olentangy Local Schools Bd. of Edn. v. Delaware Cty. Bd. of Revision, 141 Ohio St.3d 243, 2014-Ohio-4723, 23 N.E.3d 1086…, it is easy to surmise that R.C. 5713.04 is more clarification of, than exception to R.C. 5713.03.  The Olentangy Court specifically addressed this issue by asking itself:  “whether R.C. 5713.04 categorically prohibits reliance on an auction sale price as evidence of a property’s value, even when the sale satisfies former R.C. 5713.03’s requirements for a recent, arm’s-length transaction”; and answering in the affirmative, “in spite of R.C. 5713.04’s proscription, “the sale prices of parcels sold at auction are nevertheless the best evidence of value when all of the elements of an arm’s-length transaction are present.”

The court in Warrensville did pay homage to Olentangy by explaining: “In Olentangy…, we held that if the underlying transaction is an auction or forced sale, “the proponent of the sale price bears the burden to prove that the sale was nevertheless an arm’s length transaction between typically motivated parties and should therefore be regarded as the best evidence of the property’s value.”

The court in Olentangy, however provided more detailed guidance in determining what an “arms-length” transaction is. “Three factors are relevant to deciding whether a transaction occurred at arm’s length: whether the sale was voluntary; i.e., without compulsion or duress, whether the sale [took] place in an open market, and whether the buyer and seller act[ed] in their own self interest.”

In Olentangy (a residential foreclosure case), the auction sale was deemed arms length because of the following: “open-market elements”: the foreclosing lender listed the property on the open market for nine months before the auction; the auction was publicly advertised for a significant period of time, it was well attended, and there were multiple bidders for the property; the highest bid was 92 percent of the property’s final MLS list price; and the lender accepted this bid, although it had retained the right to reject it.

In contrast, according to the Warrensville court, the Thistledown sale was a “hurried sale by a debtor because of financial hardship or a creditor’s action.” In fact, “Harrah’s bought the racetrack at a bankruptcy sale … which authorizes sale of property … other than in the ordinary course of business.” “The bankruptcy court supervising the sale found ‘compelling circumstances’ to consummate the sale because there is substantial risk of depreciation of the value of Purchased Assets if the sale is not consummated quickly. Further, the transaction was not between typically motivated parties—the bankruptcy court approved the sale after finding that time was of the essence in order to maximize the value of the bankruptcy estate’s assets and that it was in the best interests of Magna Entertainment and its creditors and other parties in interest.”