Contractual Exculpatory Provisions and Procedural and Substantive Unconscionability – Some Illinois Bullet-Points

Exculpatory and limitation of damages provisions are staples of commercial transactions; especially in the service contract setting.  The former shields a contracting party from all liability (“if something goes wrong, I’m not responsible”), while the latter caps a party’s monetary damages (“if something goes wrong, my maximum liability is $100”).

For decades, cases across the land have grappled with the validity and enforceability of these contract terms.  Generally, whether a given disclaimer is upheld comes down to a fact-specific analysis of the terms’ prominence and text size (can you find it?) along with the nuances of the parties’ relationship. (is a dominant person taking advantage of a more vulnerable person?)

 Exculpatory Provisions

Illinois favors freedom of contract and exculpatory provisions are generally enforceable unless (1) it’s against public policy to do so or (2) there is something in the social relationship of the parties which weighs against enforcing the term.

Exculpatory terms are not favored and must be strictly construed against the benefitting party, especially where that party drafted the contract.

An exculpatory clause violates public policy where (1) the contract involves an employer-employee relationship, (2) is between the public and those charged with a public duty (i.e. a common carrier or utility), or (3) there is a disparity in bargaining power between the parties so that freedom of choice is lacking.

Courts also look at whether Disclaimers are unconscionable.  Procedural unconscionability applies where the disclaimer is hard to find, buried or hidden.

A contract term is substantively unconscionable where it’s blatantly one-sided and completely favors one party at the expense of the other.

 Illinois’ Construction Contract Indemnification for Negligence Act, 740 ILCS 35/1 posits that agreements to indemnify against a contractor’s negligence are void as against public policy. 

Illinois Disclaimer rules glaringly reflect the importance of pre-contract negotiation.  Parties are free to allocate risks as they see fit and where they are both sophisticated commercial entities, freedom of contract rules prevail and exculpatory clauses will be upheld – save for any public policy reasons against their enforcement.

 

 

 

Contractual Illegality and Medical Fee-Sharing

A contract law axiom states that an illegal contract is unenforceable.  The prototypical example involves a plaintiff attempting to sue on a contract that violates a statute or encourages criminal or fraudulent conduct.  Those situations clearly give rise to an illegality defense.  But what if a contract term technically violates a statute, but the resulting damage is either trivial or nonexistent? A “no harm no foul” situation.  Can the illegal contract term still be enforced?

That’s one of the questions the First District recently addressed in Ritacca v. Girardi, 2013 IL App (1st) 113511 (Sept. 2013), where a plaintiff physician sued to enforce a settlement agreement stemming from an earlier, illegal fee-sharing agreement with two of his former business partners.

After the plaintiff paid over $60,000 to settle a lawsuit filed by an equipment lender (suing on loans which were the parties’ joint responsibility), he sued his two former business partners for reimbursement under a written agreement to operate a medical facility. 

Defendants moved for summary judgment on the basis that the written agreement was unenforceable since it called for doctors and non-doctors sharing profits. The trial court agreed and granted summary judgment for the defendants.

Holding: Reversed.  Plaintiff could enforce the agreement against the defendants.

Rules/Reasons:

The contract – that amended an earlier fee-splitting agreement – clearly violated the Illinois Medical Practices Act’s (the “MPA”) anti-fee-splitting section. 226 ILCS 60/22.2(a)(physicians and non-physicians are precluded from sharing professional fees).  The agreement involved improper fee-splitting between two doctors (plaintiff and one defendant) and a lay person (the other defendant) and so was facially illegal.  ¶ 9. 

However, the Court stressed that just because a new contract stems from an earlier illegal one, this doesn’t mean the later contract is always void. As long as the new/later contract isn’t a continuation or modification of the prior illegal contract, the new contract can be upheld.  ¶ 27.

Plaintiff’s suit was premised on a second agreement that made it clear that the underlying (and illegal) first agreement was dissolved and the parties were no longer conducting business.  ¶¶ 29-30.  This led the Court to find that the second agreement wasn’t a continuation or modification of the earlier illegal agreement.

The Court ruled that the two contracts were sufficiently remote in time and substance from each other so that the plaintiff could enforce the second agreement and seek money damages from the defendants. 

The Restatement of Contracts’ Balancing Test

The Court went further and held that even if the second Agreement was sufficiently intertwined with the earlier one, the Court would still enforce it.

In Illinois, a Court can void a contract if a public policy against enforcing the contract “clearly outweighs” upholding it.  ¶ 36.  The factors that weigh in favor of enforcing a contract that violates public policy include: (a) the parties expectations, (b) the forfeiture that would result if the contract ‘t enforced, and (c) the public interest in enforcing the contract. 

The factors weighing against enforcement are (a) the strength of the policy manifested by the legislature or judicial decisions, (b) the likelihood that refusing to enforce a contract term will promote that policy,  (c) the serious of the misconduct involved, and (d) the connection between the misconduct and the contract term.  Id.

Applying these factors, the Court held that if the latter contract wasn’t enforced, it would result in a $60K plus forfeiture by the plaintiff and unjust enrichment for the defendants – since defendants were jointly responsible for the loan. 

The Court also noted that the Medical Practice Act’s dual policies of (1) discouraging profit-seeking doctors from churning their services and (2) deterring non-physicians from recommending doctors out of financial self-interest weren’t served by voiding the second agreement as the parties had long ceased doing business together.  The Court ruled that the public policy against medical services fee-sharing didn’t “clearly outweigh” allowing plaintiff to sue on the second agreement.  ¶ 40.

Lessons: Ritacca emphasizes that a technical statutory violation won’t always result in a finding of illegality.  But if a facially valid contract continues or refers to an earlier illegal one, the “new” contract will be illegal and unenforceable.  By contrast, if that new contract is far enough removed from the prior contract in time and subject matter, the new contract can be enforced.  

 

 

 

 

The Contractual ‘Pay-If-Paid’ Clause – How Broad Is Its Scope?

A pay-if-paid (PIP) clause in a construction contract says “I, the general contractor, will only have to pay you, the subcontractor, if the owner – the guy I contract with – pays me.”  Substitute “when” for “if” in the above example and you have a pay-when-paid clause.  Both of these clauses are standard in multi-layered construction projects (ones that involve multiple contractors and contracts). 

Neither term can be used to defend a mechanics’ lien foreclosure suit, though.  Section 21(e) of the Illinois Mechanics’ Lien Act (770 ILCS 60/21(e)) prevents a general contractor from using pay-if-paid or pay-when-paid provisions as a defense to a subcontractor’s mechanics’ lien claim.  But the terms are valid defenses to regular breach of contract claims. 

BMD Contractors, Inc. v. Fidelity and Deposit Company of Maryland, 679 F.3d 643 (7th Cir. 2012), examines whether a third party (i.e., a guarantor or surety) can use a PIP clause in defense of a subcontractor’s payment bond claim.  Under Indiana law, the answer is yes.

Facts:  When an Indiana manufacturer declared bankruptcy, it caused a chain reaction of defaults starting with the prime contract between the owner and the general contractor and cascading down to lower tier subs.

When the entity that hired plaintiff failed to pay, plaintiff sued the subcontractor’s bonding company under a payment bond.  The bonding company moved for summary judgment because of a PIP clause in the sub-subcontract. 

The bonding company said that since the subcontractor – the bonding company’s principal – wasn’t paid by the general contractor, the subcontractor didn’t have to pay the plaintiff.  The District Court agreed and granted summary judgment.  The plaintiff appealed.

Held: District Court affirmed.

Why?:

The Court defined a PIP clause as one that provides a subcontractor will be paid only if the contractor is paid by the owner; with each contractor bearing the risk of loss.  By contrast, a pay-when-paid (PWP) clause denotes a timing issue: the general contractor is obligated to pay the subcontractor – but only when or within a fixed time after the contractor is paid by the owner.  (p. 648). 

The Court, looking to other jurisdictions, held that the term “condition precedent” in a construction contract usually signals a PIP provision.  And viewing the unambiguous language of the operative contracts, the plaintiff’s right to  payment was only triggered if the subcontractor was paid by the general contractor.  (pp. 649-650)

Public Policy and Surety (Guarantor) Liability

The Court found that PIP terms don’t violate Indiana public policy reflected by two statutes that (1) prohibit contractual waivers of payment bond claims and (2) prevent conditioning a contractor’s right to record a lien on first receiving payment from a third person.  Indiana Code 32-28-3-16(b), 18(c). 

The Seventh Circuit held that these statutes didn’t apply to whether a contractual PIP term was a defense to a breach of contract suit.  Based on Indiana’s strong policy favoring freedom of contract, and because no statute outlaws PIP provisions as a breach of contract defense, the PIP term didn’t violate public policy. BMD at 652.

Summary judgment for the bonding company was also proper based on the general rule that a surety’s (the person guaranteeing another’s debt) obligations mirror those of its principal.  A surety can have no greater liability than its principal (the person whose debts are being guaranteed). 

In Indiana, payment bonds and the contracts they secure are construed together.  BMD at 654.  And since the subcontractor didn’t have to pay the plaintiff unless the subcontractor was paid by the general contractor, the bonding company’s obligations weren’t triggered and it didn’t have to pay the plaintiff.

Conclusions

(1) if a contract contains “condition precedent” (to payment) or similar language, this will signal a pay-if-paid clause and it will present a valid defense to a breach of contract suit;

2) lower-tier subcontractors should actively monitor the financial health of  the project so they aren’t caught off-guard by an owner’s or higher-tier contractor’s default.