Our business clients sometimes wonder “what is a liquidated damages clause?”or “is the liquidated damages clause in my contract enforceable in the state California?” We focus on answering these questions in this blog article. There are many different types of contracts in which such a clause may be useful. However, the general intentions behind liquidated damages clauses in business contracts are to help ensure a performing party is adequately motivated to perform and to help ensure the party who is to benefit from performance is adequately compensated if the performing party fails to perform, without the expense of a lawsuit.
What is a Liquidated Damages Clause?
A liquidated damages clause is one means of ensuring compensation to a non-breaching party when another party breaches the contract. Such a clause typically includes a specific amount of damages, payable to a non-breaching party in the event of a specific type of breach. The amount is determined and agreed upon during the formation of a contract and represents an “estimate” of actual damages which will be sustained by a non-breaching party in the event of a breach.
When a contract is drafted without a liquidated damages clause, the amount of damages may be determined by a court or tribunal if the parties cannot agree on a settlement. This option requires legal action and hearing or trial to determine the amount of damages sustained by the non-breach party, which is typically quite costly for all parties involved.
Here is a sample liquidated damages clause:
Party A acknowledges that the actual damages likely to result from breach of this Section “L” are difficult to ascertain on the date this Agreement is entered into and may be difficult for party B to prove in the event of a breach. Therefore, the parties intend that the payment of Liquidated Damages in the amount of Ten Thousand Dollars ($10,000) would serve to reasonably compensate B for B’s actual damages sustained, and not as a penalty, due to any breach by A of its obligations under this section “L” and A agrees to pay this amount to B for each incident of material breach of Section “L”.
Is My Liquidated Damages Clause Enforceable in California?
In the State of California, a liquidated damages clause may generally be enforced as long as the amount determined is considered, at the time the contract is entered into, to be a reasonable estimate of actual losses which will be suffered by a non-breaching party. See California Civil Code §1671. If the amount is determined to be unreasonable or its sole purpose is to punish the breaching party, and not to compensate the “innocent” party for damages resulting from the breach, it will be considered a penalty and unenforceable.
With regard to the sale of personal property or services, primarily for a party’s personal, family, or household purposes; or for a lease of real property for use as a dwelling by a party or those dependent upon a party for support, liquidated damages provisions are presumed void. However, the presumption against enforcement may be overcome where the estimate of damages is reasonable and it would be impracticable or extremely difficult to fix the amount of actual damages. Id.
These standards of enforcement are interpreted by courts and arbitrators, so it is important to consult with a knowledgeable business or contracts lawyer with access to relevant opinions to assess whether a specific liquidated damages provision is likely to be enforced. Courts typically review such language in the context of the contract as a whole, taking into account the relationship and circumstances of the contracting parties, so it is important not to assume that one size fits all with regard to liquidated damages clauses.
Tips to Determine Whether an Amount is a Reasonable Estimate of Damages?
As is apparent from the language contained in Civil Code §1671, above, determining what is a reasonable estimate of damages in the event if a breach is typically a critical assessment. Here are examples of the factors courts will use in determining whether a negotiated amount is a reasonable estimate of damages:
- Did each party have legal representation at the time the contract was drafted?
- Is the liquidated damages provision included in a form contract?
- Is the amount representative of that which could be within a reasonable range of the value of anticipated damages?
- Is it difficult to prove causation and foreseeability?
Despite a client’s desire for certainty in contracting, there is no bright line in ascertaining the validity of a liquidated damages provision. In most commercial situations, where the parties are relatively sophisticated and are engaging in an arm’s length transaction, such provisions are presumed valid unless the provision is shown to be unreasonable at the time the parties entered into the contract. Because there is no bright line defining when a liquidated damages clause will be enforced, one must take great care when drafting a contract to minimize the possibility of a court, years later, invalidating the provision. It is for this reason that most companies and many individuals opt to hire a skilled business attorney or contracts attorney to draft their contracts rather than take the risk that their contract will not be enforced.
If you are negotiating a contract, would like to have a contract prepared memorializing your agreement with another party, or need someone to review and interpret your contract, contact the trusted and experienced business law and contract law attorneys at Gehres Law Group, P.C. You’ll be glad you did.