Philip R. Kujawa is a partner in the law firm Hinshaw & Culbertson LLP. For more information, contact him at (312) 704-3558 or via email at firstname.lastname@example.org.
A pending federal class action lawsuit targeting security provider ADT has created concern about the viability of the alarm industry’s long-standing use of early termination fee (ETF) clauses. The suit — Emily Hogan et al v. ADT LLC, filed in late 2012 in the Central District of California — challenges the company's uniform price increases and ETF policies by alleging violations of the Truth in Lending Act and consumer protection laws of California and Illinois. The case is still in the preliminary pleading phase of litigation. The outcome is impossible to predict, but the courts in California have not always been supportive of the interests of the alarm industry.
ETFs serve an important function in long-term service contracts. They provide for a predetermined sum that must be paid if a party fails to perform as promised. Service providers cite the difficulty and economic inefficiency in having to calculate actual damages for each cancelling customer as a major reason for their use. ETFs also serve an important leverage function in obtaining commercial loans because the loans are often issued based on a service provider’s RMR contracts. The ETFs, therefore, provide a necessary hedge to potential losses in revenue associated with cancellation of service contracts.
ETFs are generally enforceable by courts as long as the loss associated with early termination of a service contract is difficult to calculate and the fee assessed in the contract is reasonable in light of the anticipated losses. These provisions become void where the amount of the ETF is so unreasonably large that it constitutes a penalty that would be unconscionable to enforce. There is no concrete rule as to when that line is crossed. The enforceability of these provisions may also implicate issues of compliance with various state and federal consumer protection laws.
Looking at Precedent
There are very few reported decisions discussing the enforceability of ETFs in security service contracts. In a fairly recent federal suit from the Northern District of Illinois — Maddox v. ADT Sec. Services Inc., 2011 WL 43037 (N.D. Ill Jan. 6, 2011) — an alarm company customer filed a class action suit challenging ADT’s imposition of ETFs as a violation of the Illinois Consumer Fraud and Deceptive Business Practices Act, among other things. The court dismissed the customer's claim because she failed to raise her right to relief on the alleged “substantive unconscionability claim above the speculative level.”
The ETF provision at issue required the customer to pay 75 percent of the amount she would have paid during the three-year term of the contract — i.e. 25 percent less than the amount she agreed to pay under the terms of the contract. The court found significant that the ETF provision was written entirely in capital letters and appeared at the top of the first page of a section entitled “Important Terms and Conditions.” Although the ETF was a non-negotiable term in the contract, the contract was not “so one-sided as to be unconscionable” when viewed in light of the whole contract and the other terms favorable to the customer.
Guidance on the enforceability and judicial interpretation of ETFs can be gained from more developed case law from outside the security services industry. Mobile telephone service providers have experienced challenges to ETF provisions in recent years.
The criticisms in those suits are similar to those raised by customers in the security services industry. In the mobile telephone context, customers complained that the early termination fees were being used not as a means of recovering legitimate costs, but as an anti-competitive means to lock consumers into a single service provider. Customers were unhappy with the fixed-rate termination fees that applied to long-term service contracts regardless of whether service was canceled toward the beginning, middle or end of the contract. As a response to the class actions brought against mobile service providers, almost all of those companies have implemented pro-rated ETFs that allow a customer to pay a per-month figure for the remaining time left on the contract.
ETF provisions are not enforced where the fees were excessive and bore no relation to any costs the company may incur when a consumer cancels service. It remains to be seen whether other jurisdictions will follow the more consumer friendly decisions of California courts in their treatment of ETFs as applied to the security services contracts, or simply enforce contract terms as written — exemplified by the Northern District of Illinois's decision in Maddox.
ETF Strategies for Providers
There are some useful contracting principles that can help increase the chances of enforceability of an ETF; and hopefully avoid the significant costs inherent in the defense of litigation that could transition into a class action.
Companies should base the fee on objective and reasonable costs associated with early termination. Again, there is no bright-line test as to what qualifies as objective and reasonable; however, be sure to have some calculable basis for the ETF charge. Note that security providers should be cautious of implementing blanket and costly ETF fees based on the upfront costs of installation they absorbed in obtaining the customer.
The plaintiffs in the pending federal class action against ADT argue that customers who begin their contracts after moving into a property with an existing monitoring system already installed should not have to bear the burden of those installation costs in their ETFs.
Finally, the ETF should appear conspicuously in the contract. It is useful to place the ETF in its own section or paragraph, and to use bold or larger font for titling. This helps discredit customers from claiming that they were unaware of the fees associated with terminating the contract.
Philip R. Kujawa is a partner in the law firm Hinshaw & Culbertson LLP. For more information, please contact him at (312) 704-3558 or via email at email@example.com.