To win a civil lawsuit, the plaintiff must prove the defendant is liable for whatever conduct he/she is accused of. The plaintiff must also prove that he/she has been harmed by that conduct.
Damages are the law’s approximation of the value or cost of that harm. Proving damages can sometimes be even more difficult than proving liability. Therefore, parties to a contract often attempt to predetermine damages that one party would suffer if the other breached the contract. This estimate is often included in the contract as “liquidated damages” that the breaching party must pay.
A liquidated damages provision can provide some certainty and alleviate the necessity of proving actual damages should a breach occur. However, liquidated damages provisions are also ripe for abuse. If one party has significantly greater bargaining power, that party may impose exorbitant penalties for a breach. This effectively forces the other party to comply, or guarantees a windfall. Neither of these outcomes rings true to the public policy behind contract law.
Parties are free to breach a contract, so long as they are prepared to pay the actual damages that flow from that breach.
Consider this Scenario
Imagine a lawn care provider, Mr. Crosby, contracts to mow Mr. Stills’ lawn on an upcoming Tuesday for $100. But then another homeowner, Mr. Nash, offers Crosby $1,000 to cut his lawn on the same day across town. Crosby is free to abandon the Stills job, thereby breaching the first contract, and instead mow Nash’s yard. If Stills sues Crosby and wins, Crosby will be liable for the damages that flow from his breach.
However, if the damage is less than $900 (the difference between what Crosby makes by mowing Mr. Nash’s lawn and what he would have made mowing Mr. Stills lawn), Crosby comes out ahead.
Yet, what if the $100 contract between Crosby and Stills included a liquidated damages provision? This would require Crosby to pay Stills $10,000 if Crosby fails to perform. And Crosby would lose a more lucrative opportunity, even if he was prepared to pay for the consequences of his actions.
Additionally, Stills would receive far more than is necessary to reimburse him for the actual harm he suffered.
A Liquidated Damages Clause
To guard against these outcomes, the enforceability of liquidated damages provisions is subject to legal scrutiny. Generally, parties may agree in advance on the damages to be paid in case of a breach. Provided, of course, that the amount is a reasonable estimate of the actual damages. If a court determines that the amount is excessive and functions as a penalty rather than a genuine estimate of potential damages, the provision may be deemed unenforceable.
Courts consider several factors when evaluating the reasonableness of a liquidated damages provision, including:
Relationship to Actual Damages
The stipulated amount should bear a reasonable relationship to the actual harm suffered by the non-breaching party. If the agreed-upon amount is substantially disproportionate to the anticipated damages, it may be considered a penalty and therefore unenforceable.
Difficulty of Estimating Damages
Courts will consider whether it was difficult to estimate the actual damages at the time of contract formation. Liquidated damages provisions are more likely to be enforced if it was challenging to predict the harm that might arise from a breach.
The parties must enter into the agreement in good faith. Also, the liquidated damages provision should not be a disguised penalty intended to coerce performance.
In sum, the enforceability of a liquidated damages provision hinges on the reasonableness of the agreed-upon amount in relation to the anticipated damages.
Parties should carefully draft these provisions, ensuring that they genuinely reflect a reasonable estimate of potential harm rather than serve as a punitive measure. Seeking legal advice during the contract drafting phase can help parties navigate the complexities of liquidated damages provisions. It can also enhance the likelihood of enforceability in the event of a breach.