Making sure your alarm contracts comply with the law: Part 1

March 27, 2013
Civil case raises questions about legalities of early termination fees and increasing RMR.

Editor’s note: This is part one in a two-part series from SD&I and SIW legal contributor Eric Pritchard on a California civil suit, Hogan vs. ADT, and what alarm dealers need to know about laws regarding early termination fees. Part two will examine a company’s right to increase RMR during a contract’s term.  

A recent federal court complaint filed against ADT in California calls into question two long-standing contract practices prevalent in the electronic security industry. The case could impact how alarm companies deal with a subscriber’s early termination of a monitoring contract and how alarm companies increase a subscriber’s RMR during the contract’s term. 

The case, Hogan vs. ADT, alleges that ADT’s practice of charging subscribers an early termination fee (an "ETF") is unlawful.  The complaint also alleges that ADT’s approach to increasing a subscriber’s recurring monthly revenue ("RMR") after the initial year of a multi-year contract is likewise unlawful.  The complaint was filed by lawyers who have litigated the legality of early termination fees in the wireless phone industry.  The plaintiffs are asking the federal court to certify the case as a class action on behalf of current and former ADT subscribers.  ADT has yet to file an answer to the complaint. 

The plaintiffs’ claims are instructive for alarm companies for a number of reasons. Larger companies that may be the target of class actions certainly want to avoid the expense and time resulting from class action litigation. Smaller providers want to assure their contracts are enforceable to address issues that may arise with their subscribers, including subscribers who terminate their contract early. 

The bottom line is that you should use this case as a reason to confirm that your contract complies with the law. 

Early Termination Fees

The Hogan plaintiffs attack ADT’s practice of charging an ETF where a subscriber terminates an agreement before the agreement expires.  According to the complaint, ADT charges subscribers two different types of ETFs: In some instances ADT’s ETF is a flat fee; in other instances, the ETF is a percentage of the amount due for the balance of the contract term.  According to the plaintiffs, ADT imposes ETFs even where the subscriber alleges good cause to terminate their agreement with ADT (more on good cause terminations later in this article).  The plaintiffs claim both types of ETF are really a penalty designed to keep subscribers "tethered" to ADT for as long as possible. 

Some background on ETFs is helpful. By terminating a contract without good cause before the end of its term, a party is breaching the contract. (Good cause means there is some uncured, material breach of contract.  Depending on the contract and law, good cause could also require the non-breaching party to provide the breaching party notice and an opportunity to cure any such breach.) 

In our industry the subscriber and alarm company generally agree to a specific term (usually a number of months) and that the subscriber will pay the alarm company periodically some amount of RMR for services during the term. Thus, the alarm company’s profit is premised on receiving payments during each month of the term. A subscriber’s early termination without good cause means the subscriber has not lived up to his or her bargain. Under those circumstances, the law permits the alarm company to recover its lost profits. 

A well-crafted, enforceable ETF is what lawyers call a "liquidated damages" clause. Liquidated damages is an amount one party to a contract agrees to pay the other party if the party breaches the agreement. The law requires the amount of liquidated damages to be determined in good faith and to be an estimate of the actual damages likely to result from a breach.  Liquidated damages are legally recoverable in the event of a breach. If, however, the liquidated damages is not a good faith estimate of the non-breaching party’s damages, but really a penalty designed to prevent a breach, the clause is deemed to be a penalty and is unenforceable.  A key issue is whether the damages are readily ascertainable. 

From the alarm company’s perspective, an enforceable liquidated damages clause means the alarm company does not need to go to court to establish its damages. That saves time and legal expense and it provides a sum certain to charge a subscriber who terminates their contract early without good cause. Keep in mind, however, that the law only permits a non-breaching party to recover its lost profits following a breach. 

Many alarm companies use liquidated damages clauses to protect their interests. The approach is pretty straightforward. Almost all subscriber contracts have an initial term for an agreed-upon number of months. Each month the subscriber pays a stipulated amount. Generally speaking, the total amount due under the contract can be computed when the parties enter into the contract (There will be more on this issue in my next article). A complicating factor is that many subscribers don’t pay the entire installation cost up front. Instead, they pay a portion of these costs monthly over the term of the agreement.  That should be factored into the determination of liquidated damages. If you can calculate the non-breaching alarm company’s lost profits resulting from the breaching subscriber’s early termination of the monitoring agreement, you can calculate the damages an alarm company is legally entitled to recover following a subscriber breach and you should have a legally enforceable liquidated damages provision.    

Here’s a simple example - a subscriber who terminates an alarm contract in month 12 of a 36 month term has 24 months left to pay under the contract. Assuming $50 month in RMR, the gross amount due for the balance of the contract term (24 months times $50 per month) is $1,200. The non-breaching alarm company is legally entitled to recover its lost profits, not the gross amount due under the contract. (This example assumes the alarm company has recovered its installation related costs in the first 12 months.) If it costs the alarm company $10 a month to provide monitoring services to the breaching subscriber, and the alarm company recovered the subscriber’s unpaid installation costs prior to breach, $40 of the RMR due is profit. Under this formulation, the alarm company is legally entitled to recover liquidated damages of $960 (24 months times $40 per month). 

Simple example aside, there’s plenty for lawyers and accountant expert witnesses to argue about when calculating the correct measure of contract damages and I suspect this case may be no different. In their complaint, the Hogan plaintiffs seem to be focused on the flat fee ETFs. (It appears that plaintiffs’ counsel has had some success challenging flat fee ETFs in wireless phone industry.) Given the principles outlined above, and assuming the allegations in plaintiffs’ complaint are true, I can understand counsels’ concerns about flat fee ETFs. A flat fee ETF that doesn’t decline over the term of the agreement doesn’t really seem to adequately address an alarm service provider’s lost profits. The liquidated damages formula in my form of agreement uses a formula based on a good faith estimate of the alarm company’s profit. I think that’s likely to be enforceable under the law of most states. Having said that, the litigation process in Hogan will provide the parties ample opportunity to prove their claims and defenses, including the enforceability of the flat fee ETFs. I strongly suspect ADT’s lawyers will have a reply on this issue if they file an answer to plaintiffs’ complaint. 

From the perspective of others in the industry, I recommend you use this news as an impetus to make sure your subscriber agreement, including any ETF or liquidated damages clause, complies with the law. An efficient, cost effective step in the direction of compliance is to purchase a form of agreement prepared by industry experienced legal counsel and then work with counsel to tailor these terms to your business. After all, an ounce of prevention is worth a pound of cure. 

About the AuthorEric Pritchard, the legal columnist for SD&I magazine and's LegalWatch blog, is a partner in Kleinbard Bell & Brecker LLP, Philadelphia, a commercial law firm with a national practice in the electronic security and life safety industries. He co-chairs the Electronic Security Group at Kleinbard and has 20-plus years of experience representing U.S. electronic security and life safety providers.

About the Author

Eric J. Pritchard

Eric Pritchard is a partner in FisherBroyles, a law firm with offices throughout the United States and in London. He spends his days trying to make the world safer for the security industry. You can reach Eric at [email protected].