Unenforceable clause saves contract case

The seller of a cell phone business could not enforce a default clause that called for the buyer to return the property in the event of a default.

But that clause saved the sellers’ suit to collect on the contract when an Alexandria federal court ruled the default provision was not valid.

Because the default clause was an unenforceable penalty, the seller could sue for payments the buyer failed to make within the five-year statute of limitations period for the written contract.

U.S. District Judge T.S. Ellis III said the case, Job v. Simply Wireless Inc. (VLW 015-3-622),  presented “an important threshold issue seemingly unaddressed by case law”:  whether parties may rely on unenforceable contract provision in order to show their intent that the contract should be indivisible for statute of limitations purposes.

In its analysis, the court started with whether the parties intended the installment sales contract to be divisible or indivisible, assessed the viability of the penalty clause, and then detoured into Virginia law on noncompete provisions and federal arbitration law, before deciding against dismissing the suit in its entirety.

Payments fell short

On Jan. 16, 2008, plaintiffs Matthew and Cynthia Job contracted to sell 100 percent of all stock in Carolina Cellular Sales Inc. to defendant Simply Wireless Inc. for a total purchase price of $1.5 million. The contract called for a series of payments starting in 2008 and ending in 2010.

Simply Wireless made an initial $25,000 payment on the contract but began missing payments as early as 2008. Several payments were made by defendant Mobile Now Inc., a corporate affiliate of Simply Wireless under a common ownership, according to Ellis’ opinion.

By the time the plaintiffs sued, the defendants allegedly had paid only $301,500 under the contract. The sellers’ suit alleged 13 distinct breaches of the contract.

A contract provision defined a default as a payment late more than five days, and said that if a default continued past 45 days, the sellers would “immediately receive all rights, title and interest to Carolina Cellular and Simply Wireless,” and the shareholders, officers and directors of those companies would “have no rights or continuing duties …”

Citing Virginia’s five-year statute of limitations for written contracts, Va. Code § 8.01-246(2), the buyers said the suit was time-barred.

Not necessarily, the court said.

It took no fewer than three court hearings to rule on the motion to dismiss, according to Virginia Beach lawyer Jeremiah Denton III, who represented the sellers. The issues were convoluted, as Denton noted in one of the briefs he filed.

“This case presents a fascinating and slightly diabolical legal riddle involving an exception, to an exception, to an exception, to the hoary black letter rule that the statute of limitations for breach of contract accrues upon the occurrence of the initial breach,” Denton wrote, focusing on yet another part of the sales contract.

It was the court who asked the parties to brief the issue of the contract’s default provision as a forfeiture.

General rule of divisibility

Under Virginia law, the general rule is that installment contract obligations are divisible, but the general rule can be overcome if the contract terms reflect the parties’ intent that the contract be indivisible, Ellis said.

If the contract obligations are divisible, only the breaches that occurred more than five years before suit was filed would be time-barred.

The court agreed that the contract’s default provision created “a mandatory and automatic set of obligations” that, if triggered, fully replaced the installment payment obligations with alternative and mandatory obligations, requiring the transfer of the defendant companies’ interests to the plaintiffs.

That default provision, however, was unenforceable, the court said.  There was little or no basis to suggest the sellers’ actual damages contemplated at the time of the agreement were uncertain, Ellis said. They were “the amount due and payable under the contract,” he wrote.

According to the court, the contract’s default provision  was “entirely disproportionate to the probable loss,” as an uncured breach caused Carolina Cellular to revert to the sellers, all interest in Simply Wireless to be forfeited to the sellers and allowed the sellers to keep all payments already made.

Although the default clause was unenforceable, could the intent to make the contract indivisible survive to bar the entire suit against the buyers?

No case law has been found in Virginia or other jurisdictions that squarely addresses the issue, Ellis said. In order to predict what the Supreme Court of Virginia might do, Ellis drew on Virginia’s approach to covenants not to compete and federal courts‘ application of common law in the field of arbitration clauses.

Jurisprudence in these two areas pointed persuasively to an answer: The contract’s default clause, as an unenforceable penalty, could not speak to the parties’ intent, Ellis said.

Virginia law on noncompetes takes an all-or-nothing approach that allows courts to disregard the parties’ underlying intent and to resist revising a noncompete clause to make it reasonable and enforceable, Ellis noted.

“Because penalty clauses are similarly unenforceable, it is reasonable to conclude the Supreme Court of Virginia would treat such clauses similarly to overbroad covenants not to compete,” and disregard the default clause as a manifestation of the parties’ intent that the installment contract should be indivisible, Ellis reasoned.

Similarly, federal courts recognize that an intent to arbitrate in a specific forum does not necessarily manifest an intent to prefer arbitration over litigation in all circumstances.

And here, that “the parties were content with indivisibility through the application of this specific provision does not necessarily manifest a generally applicable intent of indivisibility in all circumstances,” Ellis reasoned.

“You can’t credit intent out of a clause that is not enforceable,” Denton said.

The contract “is divisible and each failure to pay according to the installment schedule is individually actionable,” Ellis concluded.

That left most of the contract claims intact, according to Denton, including the contract’s balloon payment at the end.

Fairfax lawyer Sean P. Roche, who represented the defendant, could not be reached for comment.