What Are Liquidated Damages?
In general, liquidated damages are dollar amounts written into a contract to provide compensation to an injured party when the other violates the contract. When a violation, or breach, occurs, the injured party receives the amount of money agreed to in the contract.
Liquidated damages clauses are useful because they provide certainty in the contract while avoiding the delay and expense of having to go to court to obtain damages. The problem with liquidated damages clauses, however, is that they are frequently contested, and courts may, with some unpredictability, invalidate them.
Liquidated Damages Clauses Presumed Valid
In California, liquidated damages clauses are presumed valid as long as they are not unreasonable under the circumstances existing at the time the contract was made. This means that for a court to enforce a liquidated damages clause, the amount estimated in the contract by the parties must be the result of a reasonable attempt by the parties to estimate losses that will be suffered. If the amount is unreasonable or will be used to punish the breaching party, then the clause is considered an unenforceable penalty.
Test: Unenforceable if No Reasonable Relationship to Actual Damages
The test for enforceability is whether the liquidated damages amount bears no reasonable relationship to the range of actual damages that the parties anticipated would result from the breach; i.e., the amount acts as a penalty. Recall that the amount of actual damages actually suffered has no bearing on the validity on the provision.
Determining Whether the Amount is a Reasonable Estimate of Damages
Courts will look at a variety of factors to determine whether a liquidated damages amount is a reasonable estimate of damages. Courts consider
- The sophistication of each party;
- Whether one or both parties was/were represented by an attorney;
- Whether the parties included the provision in a form contract;
- If proof of actual damages would be costly or inconvenient;
- Whether the chosen amount is representative of a reasonable range of the value of the anticipated damages; and
- The difficulty of proving foreseeability and causation.
When Void
Liquidated damages clauses in California are presumed void in two circumstances: (1) those concerning the sale of personal property or services primarily for a party’s personal, family, or household purposes; or (2) for a lease of real property for use as a party or his dependent’s housing.
Uncertainty in Enforceability
Despite the best intentions of the contracting parties to agree to a reasonable liquidated damages amount, liquidated damages clauses may still be invalidated by a court. Because there is not a clear-cut test, it is difficult to predict whether a clause will be enforceable. For this reason, parties who want to include a liquidated damages provision should seek the advice of a business or corporate attorney.