Liquidated Damages Drafting Blunders
 

Liquidated Damages Drafting Blunders

Posted on 06-22-2018

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.

The Two Prongs

Uncertainty. The first prong of the test—the actual damages arising from a breach of the contract must be uncertain or difficult to prove with certainty—usually is not the problem. “[N]ot many cases have appeared to turn primarily” on this prong, but “a liquidated damages clause is most useful to the parties and most likely to be upheld in cases where actual damages are most difficult to prove, as in the case of a covenant not to compete ancillary to the sale of a business, for breach of a franchise agreement . . . .”6 This is because the more uncertain the damages, the greater the free reign the parties have in arriving at a reasonable estimate of them.7 The corollary is that the more certain the actual damages, the less freedom drafters have in setting liquidated damages.

In Ramada Worldwide v. Key Hotel of Brewton,8 Ramada entered into a franchise agreement with Key Hotel requiring the latter to operate a 90-room hotel under the Ramada name for 15 years. The contract provided that in the event Key Hotel breached, it would owe Ramada $1,000 per guest room. Less than four years into the contract term, Ramada terminated the franchise due to Key Hotel’s breaches. In the ensuing litigation, the court held that $90,000 in liquidated damages ($1,000 per room) was not excessive. The liquidated damages were “meant to replace the income that Ramada would have received if [not] for the premature termination of the License Agreement. . . . I  accept that such damages cannot be known with precision, and must be estimated.”

Another apt candidate for liquidated damages is a restrictive covenant that accompanies the sale of a business and obligates the seller to refrain from competing with the buyer for a certain period of time after the transaction. In the event the seller takes customers from the buyer in breach of the agreement, the buyer likely will suffer damages far in excess of the dollar amount of immediate business lost—damages that cannot be known with precision. Absent the breach, the customers wrongly taken might have remained customers of the buyer far into the future.9

All manner of agreements might be apt candidates for liquidated damages, including confidentiality and nondisclosure agreements. Breaches of these sorts of agreements might also merit injunctive relief, and a valid liquidated damages clause does not in itself bar such relief.10

Reasonable in light of anticipated or actual damages. The second prong of the test is the real battleground—it’s the reason courts generally give for holding liquidated damages unenforceable. This prong promotes the very purpose of contract law damages: to compensate aggrieved parties, not to punish breaching parties. In fact, the word “compensation” routinely pops up in judicial decisions explaining liquidated damages. When a provision stipulating to damages is punitive in nature—that is, when it is unreasonable in light of anticipated or actual damages—the provision will be stricken, but the contract otherwise will still be enforced. In that case, the aggrieved party can attempt to prove his or her actual damages with reasonable certainty. The damages may not be sufficiently certain to afford a remedy if the prospective uncertainty of damages inspired the parties to agree on a liquidated damages provision in the first place.

Though it is impossible in a short article to chronicle the many ways contracts run afoul of this prong of the test, here are some common traps for the unwary.

A Number Is Plucked Out of the Air

In Dobson Bay Club II DD, LLC v. La Sonrisa de Siena, LLC,11 a bank loaned Dobson Bay $28.6 million to purchase commercial properties. To repay the loan, Dobson Bay agreed to make interest-only payments until the loan maturity date, at which time the entire principal would be due in a balloon payment. For any delay in payment, Dobson Bay agreed to pay interest, default interest, collection costs including reasonable attorney fees, and a 5% late fee assessed on the payment amount (the 5% late fee would become the point of contention). Dobson Bay missed the deadline to make the balloon payment. The lender sued, and Dobson Bay proceeded to pay off everything— except the 5% late fee, amounting to nearly $1.4 million. The court held that the 5% late fee was an unenforceable penalty because it did not reasonably forecast the lender’s anticipated damages likely to result from an untimely balloon payment. The handling and processing costs, and the loss of use of that money, were addressed in other fees assessed against Dobson Bay aside from the 5% late fee. The lender was not able to articulate how, precisely, anything approaching $1.4 million was necessary to compensate for any other alleged damages due to a late payment.

One Size Does Not Fit All

Among the common drafting errors is to assign as liquidated damages a single dollar amount for all possible breaches, even when they vary in severity. In the Dobson Bay case, discussed above, the court found it important that the 5% late fee was payable regardless of how late a payment would be: “Five percent of the loan principal is a significant sum of money, which did not likely reflect losses from a short delay in payment. Because the fee did not account for the length of time [the lender] would be deprived of the balloon payment, the fee could not reasonably predict the Bank’s loss.”12

In another case,13 two companies offered competing training programs for cheerleading and gymnastics students. The parties explored the possibility of a complete merger and agreed that in the event they didn’t merge, they would not “contact, recruit, train or except [accept] any athlete training” with the other party for one year. The contract provided: “Violating this clause will result in a $10,000 fine.” The parties decided not to merge, and the defendant breached by contacting and recruiting plaintiff’s athletes. The court held that the contract called for an unenforceable penalty and was not based on anticipated or actual loss. It “provides for the award of liquidated damages of $10,000 whenever defendant has only contacted or recruited a student,” yet those kinds of breaches would not result in actual damages “unless the athlete moved to the other program.”14

A Penalty Can’t Be Gussied up as Liquidated Damages

To justify the agreed damages provisions in their contracts, parties routinely include pro forma language pronouncing that the agreed damages are “liquidated and not a penalty.” Courts generally don’t credit these characterizations,15 though some courts have stated that they are entitled to some weight.16 It is widely settled that the aforementioned two prongs are what really matter.

Instead of plopping boilerplate language into the contract to justify the liquidated damages provision, it would be more persuasive if the drafter succinctly summarized the specific rationale for the dollar amount chosen.

Disguised Penalties

Sometimes parties agree that one of them will pay the other a sum of money, and if it isn’t paid by a certain date, the party in breach must pay a significant additional sum. The parties often characterize this arrangement as a “discount” for early payment, but courts generally see through it and call it what it is—a disguised penalty.

In Leaman v. Wolfe,17 Leaman sued Wolfe, and the two entered into a settlement agreement that required Wolfe to execute a judgment note providing for a series of 31 installment payments totaling $475,000—plus an additional $100,000 to be “waived . . . and not . . . due and owing . . . [u]pon Wolfe’s timely payment of the . . . [31] installments.” Wolfe twice failed to make installment payments by the due dates. Per the agreement, Leaman filed a judgment note in the amount of $100,000, plus the entirety of the then unpaid balance, attorney’s fees, and costs. Wolfe challenged the $100,000 charge, and the court held it was an unenforceable penalty: “[A] $100,000 charge in the event of an untimely payment is extravagant and disproportionate to any reasonable estimate of damages accrued using the applicable interest rate.”18

Similarly, in Vitatech Internat., Inc. v. Sporn,19 Vitatech and defendants agreed to settle a dispute for $75,000, but they stipulated that Vitatech could enter judgment against the defendants in the full amount of Vitatech’s much greater original claim if the defendants did not pay the $75,000 settlement by the designated due date. Defendants failed to pay the $75,000 by the due date, and Vitatech entered judgment against defendants on the original claim for more than $300,000. The court rejected Vitatech’s argument that its agreement to accept $75,000 was merely a discount to encourage defendants to make prompt and timely payment. The $300,000 was an unenforceable penalty because it bore no reasonable relationship to the damages from defendants’ failure to timely pay the $75,000 settlement. While parties may offer a discount for prompt performance, it will be unenforceable if it is so sizable that it is in reality a disguised penalty.20

Per Diem Liquidated Damages

Many contracts state that time is of the essence for completion of construction projects and impose per diem liquidated damages for delay in completing performance.

“Since the injury caused by such delay is nearly always difficult to determine, the courts strongly incline to accept the estimate as reasonable and to enforce such provision.”21

Liquidated damages are particularly useful in imposing damages for government infrastructure contracts.22 In those cases, “the delay in use of, for example, a highway, by the public is difficult to project and measure.”23 Damages arising from a contractor’s delay are generally enforced given this uncertainty, especially where “the amounts of liquidated damages [are] graduated according to the size of the project”24 and the liquidated damages bear a reasonable relation to damages reasonably anticipated.

These sorts of clauses are so common, there is a temptation to think they are automatically enforced. Yet, in many cases, per diem liquidated damages are held to be penalties because the evidence shows that the actual damages were greatly disproportionate to the liquidated damages.25

Under the extreme case doctrine, per diem liquidated damages are not enforced because evidence affirmatively shows that the delay caused no loss whatsoever. An example: where a “race track’s completion was delayed by 10 days, but the permit for opening the race track was delayed for one month; thus, the delay in construction did not delay the race track’s opening and caused no loss.”26

Making Liquidated Damages Optional

The courts are split as to whether the contract can allow an option to choose between actual and liquidated damages. Some courts have disallowed such an option on the basis that it is penal in nature. There is a fear that with such an option, liquidated damages would only be sought when actual damages do not exceed the amount of liquidated damages. Other courts allow such an option, noting that even if actual damages appear greater, a party might opt for liquidated damages to avoid the uncertainty and proof issues associated with actual damages.27 This is another area where it is necessary to consult the law in the applicable jurisdiction.

Conclusion

Liquidated damages provisions should not be a drafting landmine—and there should not be anywhere near as many cases holding them unenforceable as there are. It’s this simple: if the parties want to include a liquidated damages provision in their contract, they need to anticipate how the contract might be breached and what damages would reasonably result from any such breaches—then they can assign a dollar figure that mirrors that forecast as their liquidated damages. The problem is, too many drafters try to use liquidated damages solely for a purpose the law doesn’t recognize: to motivate the other party to perform. These drafters are under the misapprehension that there is such a thing as unbridled freedom of contract.


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.


To find this article in Lexis Practice Advisor, follow this research path:

RESEARCH PATH: Corporate Counsel > Commercial Agreements > Breach and Remedies > Practice Notes

For guidance in determining whether a stipulated sum is for valid liquidated damages or an invalid and unenforceable penalty, see

> UCC LIQUIDATED DAMAGES

RESEARCH PATH: Corporate Counsel > Commercial Agreements > Breach and Remedies > Practice Notes

For a discussion on the intersection of liquidated damages and mitigation of damages, see

> MITIGATION OF DAMAGES IN SALE OF GOODS CONTRACTS

RESEARCH PATH: Corporate Counsel > Commercial Agreements > Breach and Remedies > Practice Notes

For a list of the types of damages that may be sought for the breach of a contract, see

> DAMAGES FOR BREACH OF A COMMERCIAL CONTRACT CHECKLIST

RESEARCH PATH: Corporate Counsel > Contract Formation > Contract Clauses > Checklists

1. See, e.g., Restatement (Second) of Contracts § 356 (Am. Law Inst. 1981) and U.C.C. § 2-718(1). 2. John E. Murray, Murray on Contracts § 126 (5th ed. 2011). 3. Make sure to check the law in the governing jurisdiction to see if it follows the modern or traditional test. Note that even if a jurisdiction has adopted the modern test, it is not uncommon for courts to still cite the traditional test—the court might have to be educated on this point. 4. XCO Int’l, Inc. v. Pac. Sci. Co., 369 F.3d 998, 1001 (7th Cir. 2004). 5. Dobson Bay Club II DD, LLC v. La Sonrisa de Siena, LLC, 393 P.3d 449, 457-458 (Ariz. 2017) (Bolick, J., dissent). 6. 11-58 Corbin on Contracts § 58.7 (2017). 7. Metlife Capital Fin. Corp. v. Wash. Ave. Assocs. L.P., 732 A.2d 493, 498 (N.J. 1999). “If the damages caused by a breach are difficult to estimate, either at the time of contracting or at the time of breach, the likelihood that a liquidated damages clause will be sustained is greatly increased.” 11-58 Corbin on Contracts § 58.7 (2017). 8. 2016 U.S. Dist. LEXIS 95790 (D.N.J. July 22, 2016). 9. Ferraro v. M & M Ins. Group, 2017 Pa. Super. Unpub. LEXIS 4551 (Dec. 12, 2017). 10. 12-65 Corbin on Contracts § 65.33 (2017). 11. 393 P.3d 449. 12. 393 P.3d 453. 13. Premier Gym & Cheer v. All-American Cheer & Dance Elite, 2016 Pa. Dist. & Cnty. Dec. LEXIS 17545 (July 13, 2016). 14. Id. at *8-9. 15. Wilmington Housing Authority v. Pan Builders, Inc., 665 F. Supp. 351 (D. Del. 1987). 16. Walter Motor Truck Co. v. State, 292 N.W.2d 321 (S.D. 1980). 17. 629 Fed. Appx. 280 (3d Cir. 2015). 18. Id. at 283. 19. 16 Cal. App. 5th 796 (2017). 20. See also Wis-Bay City, LLC v. Bay City Partners, LLC, 2009 U.S. Dist. LEXIS 49806 (N.D. Ohio June 12, 2009). Where the contract spells out a late charge for failure to pay a sum of money owed that is significantly larger than the sum owed beyond the interest value of the sum owed and lost opportunity costs, courts have little difficulty finding the provision unenforceable. 21. 11-58 Corbin on Contracts § 58.21 (2017). 22. Boone Coleman Constr., Inc. v. Vill. of Piketon, 50 N.E.3d 502 (Ohio 2016); United States ex rel. Ash Equip. Co. v. Morris, Inc., 2017 U.S. Dist. LEXIS 126509 (D. S.D. Aug. 8, 2017). 23. 2017 U.S. Dist. LEXIS at *43. 24. Id. 25. Brinich v. Jencka, 757 A.2d 388 (Pa. 2000). See also 11-58 Corbin on Contracts § 58.21 (2017). 26. Int’l Marine, L.L.C. v. FDT, L.L.C., 619 Fed. Appx. 342, 351, n. 9 (5th Cir. 2015), citing Restatement (Second) of Contracts § 356 cmt. b, ill. 4 (Am. Law Inst. 1981). 27. See Ravenstar, LLC v. One Ski Hill Place, LLC, 401 P.3d 552 (Colo. 2017), explaining the two positions