Liquidated Damages Drafting Blunders

June 23, 2018 (4 min read)

By: Timothy Murray, Murray, Hogue & Lannis

Parties drafting contracts often want to set in stone the precise dollar amount of damages that will be awarded in the event of a breach, commonly called liquidated damages. The idea is that if a breach occurs, this provision makes it unnecessary for the aggrieved party to prove actual damages. The benefits of such a provision—promoting certainty and eliminating the litigation expense of proving damages—are obvious.

BUT EVEN WHEN THESE PROVISIONS ARE FREELY ENTERED into by sophisticated parties, they are often not enforced. The fact that clients, and it seems too many attorneys, do not understand why they aren’t enforced can lead to costly drafting errors.

In order for a liquidated damages provision to be enforceable (1) the loss or harm from a breach of the contract must be uncertain or difficult to prove with certainty, and (2) the liquidated damages must be reasonable in light of the anticipated or actual damages caused by the breach.¹ The second prong of this test is a modification of the traditional common law test, which required liquidated damages to be a reasonable forecast of damages at the time of contract formation.² In contrast, the modern test allows a second look— even if liquidated damages were an unreasonable forecast at the time of contract formation, the provision will be enforced if it turns out to be a reasonable approximation of the actual damages incurred.³

For attorneys steeped in the tradition of freedom of contract, a rule that negates a freely negotiated provision might seem jarring. Esteemed former Judge Richard Posner called the law of liquidated damages “mysterious” and voiced what a lot of attorneys have pondered: “[I]t is difficult to see why the law should take an interest in whether the estimate of harm underlying the liquidation of damages is reasonable. Courts don’t review the other provisions of contracts for reasonableness; why this one?”⁴

Another jurist provided a more biting critique:

As children, we learn that the rules of the playground dictate that if someone makes a promise, no matter how solemnly, it is unenforceable if the person making the promise had his fingers crossed behind his back. As we grow up, we learn instead that many promises are moral and legal obligations, with consequences properly attached to breaking them. Still, some grown-ups prefer the playground rules.⁵

If the law of liquidated damages is baffling for judges, it can be downright nonsensical to clients who often want to include a liquidated damages provision in their contracts, not to provide a reasonable estimate of possible damages but to motivate the other party to perform. The thinking goes, if the agreed damages are sufficiently severe, the other party will be all the more reluctant to breach. While there is nothing wrong with using liquidated damages to motivate the other party to perform, clients need to understand that the amount of liquidated damages can’t be plucked out of the air—it must bear a reasonable nexus to the actual harm, anticipated or actual.

Why are so many liquidated damages provisions held to be unenforceable, and how can this result be avoided? A closer look at the two-prong test is necessary.

To read the full practice note in Lexis Practice Advisor, follow this link.

Timothy Murray, a partner in the Pittsburgh, PA law firm Murray, Hogue & Lannis, is co-author of the Corbin on Contracts Desk Edition (2017) and writes the biannual supplements to Corbin on Contracts.