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KKO, INC. v. HONEYWELL

United States District Court, Northern District of Illinois, E.D


May 4, 1981

KKO, INC., ET AL., PLAINTIFFS,
v.
HONEYWELL, INC., DEFENDANT.

The opinion of the court was delivered by: Shadur, District Judge.

MEMORANDUM OPINION AND ORDER

Defendant Honeywell, Inc. ("Honeywell") formerly sold parts to plaintiffs KKO, Inc. ("KKO") and Keating of Chicago, Inc. ("Keating"), to be incorporated into electric deep fat fryers ("fryers") manufactured by plaintiffs for sale to commercial establishments. Plaintiffs now sue Honeywell for breach of warranty and fraudulent misrepresentation in connection with Honeywell's sales. Counts III and VIII of plaintiffs' Amended Complaint (the "Complaint") seek direct and consequential damages for the alleged breach of warranty. Honeywell has moved for summary judgment as to any consequential damages, relying on a contract provision that expressly precludes such relief. Plaintiffs claim that provision is ineffective because (1) Honeywell's warranty "failed of its essential purpose" and (2) the provision is unconscionable. For the reasons stated in this memorandum opinion and order Honeywell's motion is denied, but this Court concurs in Honeywell's legal position as to the scope of application of the unconscionability defense.

Facts

KKO and Keating are related corporations engaged in the business of manufacturing, designing and selling ovens, fryers and other cooking equipment to food-related businesses. KKO is one of the largest manufacturers and Keating one of the largest distributors of fryers in the United States.

Until 1972 KKO purchased from Honeywell electrical contactors ("contactors") for installation in their bun toasters and ovens. Contactors regulate the flow of electricity through such cooking units by use of magnetic pole faces ("E and I magnets"). During operation of a cooking unit the magnets are normally in contact with each other, closing the circuit so that electric current flows through the unit. When the unit reaches a preset temperature the magnets automatically disengage, breaking the electrical circuit until the temperature again falls below the designated level. At that point the circuit again closes and the electrical flow is restored.

In 1972 plaintiffs began manufacturing and selling fryers. Like the bun toasters and ovens, fryers were designed to use contactors as temperature controls. Plaintiffs determined that the Honeywell contactors used in bun toasters and ovens were also usable without alteration in fryers, and they began to purchase contactors from Honeywell for their new product. Individual purchase orders sent to Honeywell by KKO stated the contactors would be used on commercial cooking equipment, but at least initially Honeywell was not specifically informed that they would be used in fryers. Upon receiving each purchase order Honeywell sent KKO an "acknowledgement" (the "contract"), on the back of which was printed the following terms:

  1. GUARANTEE. The Company warrants all equipment
  manufactured by it or bearing its nameplate to be
  free from defects in workmanship and materials, under
  normal use and service, as follows: (a) Equipment not
  installed by the Company which is received,
  transportation prepaid, at the factory originating
  shipment (i) within twelve months after date of
  manufacture, or (ii) within twelve months after date
  of installation, as evidenced by a certification by
  the installer, and is found by the Company's
  inspection to be defective in workmanship or
  materials within the guarantee, will be repaired or
  replaced, at the Company's option, free of charge and
  returned transportation prepaid. (b) Equipment
  installed by the Company, or under the direct
  supervision of the Company, which within twelve
  months after date of installation, is found by the
  Company inspection to be defective in workmanship or
  materials with the guarantee, will be repaired or
  replaced, at the Company's option, free of charge. If
  inspection by the Company does not disclose any
  defect covered by this guarantee, the equipment will
  be repaired or replaced and the Company's regular
  service charges will apply. WITH EXCEPTION OF THE
  TWELVE MONTH WARRANTY SET FORTH ABOVE, THE COMPANY
  MAKES NO EXPRESS WARRANTIES, NO WARRANTIES OR
  MERCHANTABILITY AND NO WARRANTIES WHICH EXTEND BEYOND
  THE DESCRIPTION OF THE FACTS HEREOF. In no event will
  the Company be responsible for consequential damages
  of any nature whatsoever.

Until February 1973 Honeywell had used Speedfam 205 oil as the "lapping compound" in its contactors. Lapping compounds are lubricants that facilitate "grinding down and making smooth" the E and I magnets, allowing the contactor to function properly. In mid-February 1973 Honeywell began to mix a new lapping compound, Speedfam 210 oil, with Speedfam 205. Next month, when its supply of the 205 compound was exhausted, Honeywell began to use only the 210 compound.

Honeywell assumed the two compounds were functionally interchangeable. But because of the manner in which Speedfam 210 interacted with the magnets and with silicon particles and iron filings in the chambers of the contactors, it produced a sticky adhesive substance that could (and on occasion did) cause the contactor to stick in the "power on" position. Temperature in the fryer would then escalate beyond the designated level and create a serious fire hazard.

Sales to plaintiffs continued without interruption until November 1973, when Honeywell discovered that contactors bearing the manufacturing date codes CW through KW (corresponding to the period March 1973 to November 1973) were thus potentially defective. Honeywell then commenced a nationwide recall of the contactors in which Speedfam 210 had been used, allegedly 200,000 in number, including those purchased by plaintiffs.*fn1 Honeywell obtained a list of plaintiffs' customers and replaced the existing contactors with completely new models.

Plaintiffs contend they too were promised new contactors in exchange for the models still in their possession (and therefore unused). However, Honeywell repaired rather than replaced the unused contactors by disassembling them and cleaning the E and I magnets with a vapor degreaser. Honeywell deleted the original manufacturing code date on each repaired contactor and replaced it with a new one. In addition, Honeywell apparently "cleaned" a large quantity of the E and I magnets from used contactors and used them in "new" contactors later offered for sale.

Plaintiffs continued to purchase contactors from Honeywell. Then in late 1974 they complained that a number of contactors not subject to Honeywell's recall campaign were malfunctioning. Honeywell examined certain of those contactors and determined that the malfunctions were attributable to the seepage of cooking grease into the contactors. It therefore concluded the malfunctions were caused by "an incorrect application rather than a product defect" and that those malfunctions were accordingly not covered by its warranty.

Plaintiffs assert that the defective contactors are those in which recalled, rather than new, E and I magnets were used and that the defects are attributable to the fact that Honeywell's cleaning process failed to "decontaminate" those magnets. As Honeywell concedes, the cleaning process did not remove all Speedfam 210 from the magnets. However Honeywell contends that the residue "was insufficient to cause a failure in a proper application of the contactor." Plaintiffs claim the residue migrates to the surface of the magnets, causing the same problem that led to the recall. Furthermore they allege that Honeywell knew or plainly had reason to know that the cleaning process would be ineffective.

When Honeywell refused to repair the malfunctioning contactors plaintiffs commenced their own recall program to replace all Honeywell contactors in their fryers. In this action they seek damages occasioned by the contactor malfunctions, including lost profits and consequential expenses allegedly incurred because of their own recall program.

Plaintiffs' Legal Theories

Paragraph 1 of the reverse side of the contract includes three provisions relevant to Honeywell's motion. First it warrants the contactors to be "free from defects in workmanship and materials, under normal use and service . . ." (the "warranty"). Second it limits a purchaser's "remedy" for any such defect to repair or replacement by Honeywell (the "limited remedy clause"). Finally it states, "In no event will the Company be responsible for consequential damages of any nature whatsoever" (the "exclusion clause").

Thus the unambiguous contract language supports Honeywell's assertion that it cannot be held responsible for any consequential damages under the warranty. Plaintiffs do not dispute the general enforceability of such limited remedy and exclusion provisions under Illinois law.*fn2 Plaintiffs contend, however, that the exclusion clause is invalid under either of two theories:

    1. In this instance the limited remedy "failed of
  its essential purpose" and therefore under Code
  Section 2-719(2) plaintiffs may obtain consequential
  damages.

    2. Honeywell's exclusion clause is unconscionable
  and thus unenforceable under Code Section 2-719(3).

1. Section 2-719(2): Failure of Essential Purpose

Section 2-719(2) states:

  Where circumstances cause an exclusive or limited
  remedy to fail of its essential purpose, remedy may
  be had as provided in the Act.

Under Section 2-714(3) "remedy . . . as provided in the Act" includes "in a proper case any incidental or consequential damages." Plaintiffs reason that where the limited remedy of a contract "fails of its essential purpose," consequential damages are recoverable notwithstanding an otherwise valid exclusion clause.*fn3

Honeywell counters that failure of essential purpose under Section 2-719(2) does not permit recovery of consequential damages in the face of an express exclusion clause. Such clauses are specifically authorized by Section 2-719(3) subject to the condition that they are not unconscionable. Honeywell reasons that the validity of any such clause must be assessed against the unconscionability standard of Section 2-719(3) and that standard alone. In short Honeywell contends that Sections 2-719(2) and (3) are separate and distinct, so that an enlargement of plaintiffs' remedial alternatives via the former does not override a limitation of remedy valid under the latter.

Both plaintiffs and Honeywell seek to draw support from a significant number of decisions in other jurisdictions*fn4 interpreting the Uniform Commercial Code. But in this diversity action the Court must decide all substantive questions in accordance with Illinois law under the seminal case of Erie R.R. Co. v. Tompkins, 304 U.S. 64, 58 S.Ct. 817, 82 L.Ed. 1188 (1938).

Honeywell cites two decisions involving Illinois law in support of its position. In V-M Corp. v. Bernard Distributing Co., 447 F.2d 864 (7th Cir. 1971) counterclaimant, an electronic equipment distributor, sought direct and consequential damages from plaintiff for supplying it with allegedly defective goods. Plaintiff invoked limited remedy and exclusion clauses to defeat counterclaimant's consequential damage claim. Counterclaimant argued that because the limited remedy failed of its essential purpose under Section 2-719(2) the exclusion clause was ineffective. Our Court of Appeals held that the limited remedy had not failed its essential purpose. However the Court also stated (447 F.2d at 869):

  Moreover, we are not persuaded that Section 2-719(2)
  otherwise requires the negation of the specific
  limitations of the contract. Section 2-719 was
  intended to encourage and facilitate consensual
  allocations of risks associated with the sale of
  goods. This is particularly true where commercial,
  rather than consumer sales are involved. Even where
  defects of the goods cause substantial
  difficulties . . . Section 2-719(2) need not
  automatically require disregard of the particular
  limitations upon liability specified by the
  contracting parties. Here we cannot say that the
  defects in the quality of [plaintiff's] . . . goods
  caused a failure of consideration for the . . .
  agreement which would justify altering the particular
  allocation of these costs by making the manufacturer
  the insurer of distributor profits and extraordinary
  expenses.

AES Technology Systems, Inc. v. Coherent Radiation, 583 F.2d 933 (7th Cir. 1978) is the second "Illinois case"*fn5 on which Honeywell relies. Plaintiff sued for breach of warranty respecting a laser it had purchased from defendant and sought direct and consequential damages. Defendant asserted that a limited remedy clause precluded such relief, but plaintiff responded that the clause had failed its essential purpose under Section 2-719(2). Although the parties' contract did not contain an express provision excluding consequential damages the Court found such a condition to be implicit in the fact that the repair and replacement warranty was expressly exclusive (583 F.2d at 941 n. 9).

Our Court of Appeals held that the limited remedy clause had failed its essential purpose but, quoting the passage from V-M Corp. set out above, also held that consequential damages were non-recoverable. It went on to say (583 F.2d at 941):

  [W]e reject the contention that failure of the
  essential purpose automatically means that a damage
  award will include consequential damages. An analysis
  to determine whether consequential damages are
  warranted must carefully examine the individual
  factual situation involved. . . . The purpose of the
  courts in contractual disputes is not to rewrite
  contracts by ignoring parties' intent; rather, it is
  to interpret the existing contract as fairly as
  possible when all events did not occur as planned.

In response plaintiffs cite Adams v. J.I. Case Co., 125 Ill. App.2d 388,
261 N.E.2d 1 (4th Dist. 1970) in support of their position. In Adams plaintiff purchased a tractor from defendant and sued for the cost of repair and lost earnings after the tractor broke on several occasions. Defendant relied in part on limited remedy and exclusion clauses, quite similar to those in this case, in contesting plaintiff's claim. First the Appellate Court determined that defendant had unreasonably and wilfully failed to meet its repair or replacement obligation under the warranty and therefore that the limited remedy clause had "failed of its essential purpose" under Section 2-719(2). Notwithstanding the express exclusion clause, the Court then held that consequential damages were recoverable (125 Ill.App.2d at 402-03, 261 N.E.2d at 7-8):

  The limitations of remedy and of liability are not
  separable from the obligations of the warranty.
  Repudiation of the obligations of the warranty
  destroys its benefits. The complaint alleges facts
  that would constitute a repudiation by the defendants
  of their obligations under the warranty, that
  repudiation consisting of their wilful failure or
  their careless and negligent compliance. It should be
  obvious that they cannot at once repudiate their
  obligation under the warranty and assert its
  provisions beneficial to them.

There is obvious incongruity between V-M Corp. and AES Technology Systems on the one hand and Adams on the other. Honeywell asserts that the Seventh Circuit decisions are dispositive of its motion. But in a diversity action that would be true only if those decisions accurately mirror Illinois law. Erie requires this Court to decide state substantive law questions in the same way that its state trial judge counterpart sitting in the same location would. National Can Corp. v. Whittaker Corp., 505 F. Supp. 147, 148-49 n. 2 (N.D.Ill. 1981); Instrumentalist Co. v. Marine Corps League, 509 F. Supp. 323,339 (N.D.Ill. 1981).

Under Illinois law a trial judge in the First Appellate District is bound by the decisions of all Appellate Courts unless two or more districts are in conflict. People v. Thorpe, 52 Ill. App.3d 576, 579, 10 Ill.Dec. 351, 354, 367 N.E.2d 960, 963 (2d Dist. 1977). In contrast, federal Court of Appeals decisions applying state law do not bind a state trial court, for federal appellate courts engage only in the same process as this Court must: "acting" as a state trial court. Accordingly to the extent that Adams and V-M Corp. and AES Technology Systems are inconsistent, Adams is controlling as to the question presented here.*fn6

Adams plainly requires that Honeywell's motion be denied. Honeywell's argument is essentially that as a matter of law the validity of an exclusion clause is unaffected by the fact that a limited remedy has failed of its essential purpose. That contention was rejected by Adams, a case in which failure of a limited remedy's essential purpose was held to permit recovery of consequential damages notwithstanding an express clause excluding any such recovery. Adams cannot be distinguished on its facts:*fn7 Plaintiffs in this case could prove facts that, under the law announced in Adams, would plainly justify disregard of the exclusion clause.

Even if, despite the above discussion, V-M Corp. and AES Technology Systems were viewed as controlling declarations of Illinois law, they would not mandate a different outcome on this motion for summary judgment. In order to prevail Honeywell must demonstrate as a matter of law — in other words, either in all factual circumstances or on the uncontroverted facts — that its exclusion clause would be unaffected by a "failure of the essential purpose" of the limited remedy clause. In V-M Corp. the Court said that on the facts before it "we cannot say that the defects in the quality of [plaintiff's] . . . goods caused a failure of consideration . . . which would justify altering the particular allocation of [the] . . . costs [agreed to by the parties]. . . . We see nothing in this record to justify protection of the distributor's profits or expenditures at the expense of the manufacturers" (447 F.2d at 869, emphasis added). Similarly in AES Technology Systems the Court stated, "An analysis to determine whether consequential damages are warranted must carefully examine the individual factual situation involved. . . . The intent of the parties, as gleaned from the express provisions and the factual background, was for AES to bear the risk of the project" (583 F.2d at 941, emphasis added).

Both decisions thus leave open the prospect that factual circumstances may permit an award of consequential damages where a limited remedy has failed its essential purpose, notwithstanding an exclusion clause.*fn8 Such factual issues may not of course be resolved on a motion for summary judgment.

2. Sections 2-302(1) and 2-719(3): Unconscionability

Honeywell also seeks to establish that the exclusion clause is not unconscionable. In light of this Court's ruling in the preceding section of this opinion, a determination favorable to Honeywell on the unconscionability issue would not affect the outcome of its present motion. But because disposition of the issue at the present juncture may expedite further proceedings, the Court will discuss the proper scope of the unconscionability defense under the circumstances of this case.

Section 2-719(3) states, "Consequential damages may be limited or excluded unless the limitation or exclusion is unconscionable." Section 2-302(1) is the general unconscionability provision of the Code:

  If the court as a matter of law finds the contract or
  any clause of the contract to have been
  unconscionable at the time it was made the court may
  refuse to enforce the contract, or it may enforce the
  remainder of the contract without the unconscionable
  clause, or it may so limit the application of any
  unconscionable clause as to avoid any unconscionable
  result.

Plaintiffs claim the exclusion clause is unconscionable because "Honeywell's conduct in this case was oppressive and worked an unfair surprise on Keating and KKO. . . ." They argue that "Honeywell, in a position of superior knowledge, chose to conceal the defect [the allegedly contaminated E and I magnets used in new contactors] . . . and knowingly permit a dangerous product to be used. To permit Honeywell to flagrantly breach its warranty and now attempt to ignore with impunity the severe losses inflicted on . . . [plaintiffs] is manifestly unconscionable."

Those assertions, essentially sounding in fraudulent concealment (and to that extent actionable under appropriate tort theories), are not at all relevant to the question whether the exclusion clause is unconscionable. Section 2-302(1) addresses a wholly different consideration from that raised by plaintiffs. As stated by the Illinois Appellate Court in Neal v. Lacob, 31 Ill. App.3d 137, 142, 334 N.E.2d 435, 439-40 (1st Dist. 1975):

  Traditionally an unconscionable bargain has been one
  "which no man in his senses, not under delusion,
  would make, on the one hand, and which no fair and
  honest man would accept on the other. . . ." The term
  is used to signify a contract that is totally
  one-sided or oppressive. . . . In the context of
  dealings between businessmen, the unconscionability
  doctrine has been applied to protect those in need of
  goods or services from being overreached by others
  who have the power to drive hard bargains. . . .

That view, under which "unconscionability" relates to the use of bargaining position or power to command an inherently unfair contract, is confirmed by the Official Comment to Code Section 2-302:

  The basic test is whether, in light of the general
  commercial background and the commercial needs of the
  particular trade or case, the clauses involved are so
  one sided as to be unconscionable under the
  circumstances at the time of the making of the
  contract.

Although plaintiffs have argued vigorously that Honeywell's conduct in this matter was deceitful, fraudulent and in violation of its obligations under the warranty clause, they have all but ignored the factual issue critical to unconscionability claims: the relative bargaining positions of the parties and the consequences of those relative strengths when the contract was entered into. Honeywell, on the other hand, has amply supported its contention that the contract between it and plaintiffs was entered into under fair circumstances by unconscionability standards. Plaintiffs have been in the business of manufacturing and selling commercial cooking equipment for over forty years and are among the largest manufacturers and distributors of fryers in the country. Competitive brands of contactors were available. Most importantly, nothing in the process by which plaintiffs agreed to purchase contactors from Honeywell suggests "overreaching" or any other pressure tactics, and the resulting contract is at the least facially a fair one.*fn9

Adams Laboratories considered a similar question. Plaintiff there alleged that defendant had fraudulently induced it to enter into their contractual relationship and, based on that claim, argued that an exclusion provision in the contract should be disregarded. Plaintiff's argument was rejected (486 F. Supp. at 388):

  Fraudulent inducement would form the basis for
  rescinding this limitation [the exclusion clause] if
  the fraud related directly to the plaintiff's
  acceptance of the provision. . . . Such is not the
  case here. Thus, although the alleged fraudulent
  inducement might entitle plaintiff to damages
  irrespective of the contract, it does not empower the
  plaintiff to enforce certain provisions of the
  contract which are to its liking and excise the rest.

Plaintiffs' allegations of fraudulent concealment stand on analogous ground in relation to their unconscionability argument. Because plaintiffs have not raised any other claims demonstrating alleged unconscionability of the exclusion clause, there are no issues of material fact as to that contention and Honeywell is entitled to a ruling in its favor on the issue as a matter of law.

Conclusion

Honeywell's motion for summary judgment is denied. However the Court finds that there is no genuine issue as to any material fact bearing on the question whether the contract between Honeywell and plaintiffs is "unconscionable" within the meaning of Code Section 2-719(3). Accordingly the Court concludes that Honeywell is entitled to a determination as a matter of law that the contract is not unconscionable.


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