A Return to the Classic Analysis of Liquidated Damages Clauses

A Return to the Classic Analysis of Liquidated Damages Clauses

 
 
The classical view enforces liquidated damages clauses constituting a reasonable estimate of damages in the event of breach. Under the modern view, they are enforceable if they are prospectively reasonable with respect to anticipated harm or retrospectively reasonable with respect to actual injury. Dr. John E. Murray, Jr. discusses both views in the context of Carothers Constr. Co., LLC v. City of South Hutchinson, 207 P. 3d 231 (2009).
 
One of the classic justifications for the enforcement of liquidated damages clauses is the prospective inability to prove actual damages with reasonable certainty. Thus, the classical view made a liquidated damages clause constituting an honest and reasonable estimate of damages in the event of a breach enforceable. Section 2-718(1) of the Uniform Commercial Code made an important change in this requirement in contracts for the sale of goods that was replicated in Restatement (Second) of Contracts §356(1) for other types of contracts. It announced a much more flexible approach by stating that the amount in the liquidated damages clause must be reasonable in the light of the anticipated or actual harm caused by the breach. Under this modern view, liquidated damages clauses become enforceable if they are either prospectively reasonable with respect to anticipated harm (a first look or single look or foresight view) or retrospectively reasonable with respect to actual injury (second look or hindsight perspective).

The change was not without its critics. Early on, Professor (later Judge) Ellen Peters noted that the UCC "was unusually generous in the amount set by the contracting parties. Even if this amount was entirely unreasonable, as of the time of contract, it can apparently be recovered so long as it turns out, purely as a matter of accident, to approximate the harm actually caused by the breach." E. Peters, Remedies for Breach of Contract Relating to the Sale of Goods Under the Uniform Commercial Code: A Roadmap for Article Two, 73 Yale L.J. 199, 278 (1963).

A correlative critical analysis is patently clear. Under the flexible view, a contract containing a liquidated damages amount that is clearly unforeseeable and intended as a penalty at the time the contract is formed can become enforceable through the sheer accident of unusual actual damages accidentally bearing a reasonable relation to the amount in the clause. The change, therefore, could support clear violations of the sacred rubric of Hadley v. Baxendale, 156 Eng. Rep. 145 (1854), which continues to be regarded as the critical foreseeability limitation on recoverable contract damages. Foreseeability is measured at the time the contract is formed. If a clause contains an amount for damages that is clearly unforeseeable but accidentally turns out to be a reasonable amount in relation to actual unforeseeable damages, the clause is enforced. At the time the contract was formed, the clause was clearly intended as a penalty. Thus, its enforcement also undermines the fundamental policy of refusing to enforce penalty clauses since contract law is dedicated to reasonable compensation for losses suffered rather than punitive damages.