The term "liquidated damages" describes an agreement between contracting parties to set a fixed monetary remedy in the event of breach of a contract. In other words, the parties to a contract stipulate up front to the amount that the breaching party will owe the non-breaching party. At their best, liquidated damages clauses provide a means for parties to avoid costly disputes as to the amount of financial damages suffered as a result of one party's breach of an agreement. However, and unfortunately, liquidated damages clauses are generally misunderstood and often incorrectly formulated. At their worst, liquidated damages clauses can become the center of an entirely separate legal dispute, ultimately resulting in a scenario far different and more expensive than what the parties originally intended.
This article will explore the background of liquidated damages clauses in business contracts, contrast the general benefits and drawbacks of their inclusion, set out enforceability scenarios under North Carolina law, and offer practical advice for properly utilizing such clauses.
What Are Liquidated Damages Clauses?
There are two questions in almost every lawsuit regarding a breach of contract:
- Is one of the parties liable to another for monetary damages ("Liability Phase"); and,
- If so, how much money is owed ("Damages Phase").
In the Liability Phase, the complaining party seeks to prove that the other party is responsible under the law for some action or omission, such as breach of contract. In the Damages Phase, the litigant who has proven liability seeks to quantify the amount it is entitled to recover on account of the other party's conduct. This is an important distinction, as it is common for plaintiffs to focus on whether the other party did something wrong rather than how much harm resulted in monetary terms. Litigation over the amount of damages can be as intricate and hotly contested as the liability of a party.
In the world of business litigation, it is vitally important for a party to be able to put a price on the wrong it has suffered. For example, if a tenant vacates a space prior to the expiration of a lease, the tenant likely has breached the lease. But, if another tenant moves in the next day and begins paying rent, the financial damages suffered by the landlord likely are minimal or nonexistent. For this reason, a savvy landlord will recognize that litigation over liability would be a waste of time and money.
A liquidated damages clause is nothing more than an agreement between the parties as to how much money will be owed by a breaching party to a non-breaching party in the event of a breach. In other words, the parties essentially agree to the amount that otherwise would be fought over in the Damages Phase of the litigation.
Liquidated damages clauses are common in many different types of contracts. The most common example is found in purchase contracts for real estate, when a buyer and a seller agree that the amount of the earnest money deposit will be delivered to the seller as the seller's sole remedy if the buyer backs out of the purchase. Another common example of a liquidated damages clause arises in the construction context. Construction entities often agree that a certain amount is owed for every day of delay caused by a breaching party.
What Are the Benefits?
The primary benefit of liquidated damages clauses is that they allow the contracting parties to compare the value of performance of the contract against the costs of a breach. This allows them to monitor the economic justification for a contract and to act accordingly. Depending on the amount of the liquidated damages agreed upon, these clauses can serve as a significant deterrent to breach.
Perhaps most importantly, liquidated damages clauses can save the parties significant amounts of costs and legal fees because, when enforceable, these clauses can essentially narrow the issues for trial by resolving in advance the Damages Phase of the case. At that point, the litigation is narrowed to only the Liability Phase which streamlines the overall case.
To summarize, when an enforceable liquidated damages clause is present, the parties have a simple and easy understanding of the consequences of their breach and the value of the contractual relationship to the other party and can avoid the risks and costs of litigating the Damages Phase.
What Are the Drawbacks?
First, the enforceability of liquidated damages clauses can become an issue. Enforceability is more fully addressed below, but suffice it to say that the enforceability of a liquidated damages clause can become its own freestanding litigation issue.
Second, surprising as it may sound, uncertainty as to the amount of damages due, while possibly costly to explore and prove, affords the parties significant flexibility in determining the actual amount that they have been harmed. The parties actually may benefit from having an objective court and/or jury involved in that determination.
Setting a damages amount in advance by way of a liquidated damages clause can be risky in that it can be hard to forecast actual damages. In some situations, liquidated damages clauses can provide too little of a recovery. In at least one case heard by the North Carolina Business Court, a plaintiff argued that a liquidated damages clause to which the party had agreed was unreasonable and, thus, unenforceable, because it did not afford enough recovery. That argument failed. By contrast, a liquidated damages clause also can provide for more than the plaintiff may otherwise have been entitled, reducing the value of what may otherwise have been a viable damages defense for the breaching defendant.
When Are Liquidated Damages Clauses Enforceable?
In North Carolina, the courts give great deference to parties to fashion their commercial contracts as they see fit. In keeping with this general principle, commercial parties generally, in the absence of duress or unconscionability, are allowed to agree to limit or manipulate their legal remedies against one another.
However, liquidated damages clauses cannot be a penalty. In order to determine whether a liquidated damages clause is penal in nature, rather than a stipulation of a reasonable damage amount, North Carolina courts ask two primary questions:
- Whether the damages the parties reasonably anticipate from a potential breach are difficult to ascertain because of their indefiniteness or uncertainty; and,
- Whether the amount stipulated is either a reasonable estimate of the damage which probably would be caused by a breach or is reasonably proportionate to the damages which have actually been caused by the breach.
However, it is very important to note that North Carolina courts have placed the burden of proving that a liquidated damages clause is unenforceable on the party who has been found liable in the Liability Phase of a case. And that burden is quite high because liquidated damages clauses are typically used only when damages are difficult to ascertain. By definition, if damages are difficult to ascertain, it is correspondingly difficult for the party held liable to prove that a liquidated damages amount actually is unreasonable.
Of course, there are cases where it is not hard to show that a liquidated damages amount is unreasonable and, thus, unenforceable. A good example of where a liquidated damages clause could be found to be unreasonable and unenforceable is where a contract exists for the sale of goods and there is a readily ascertainable market price for those goods. If a party breaches a contract for the sale of those goods, the damages are ascertainable because the market price for the goods will determine exactly what was lost. If the contract was for $100 per widget, and the market price for that widget is $90, the seller has lost $10 per widget if the buyer breaches the contract to purchase the widgets.
Contrast the widget case with a situation where a construction project is delayed on account of a breach and a daily liquidated damages sum has been agreed to by the parties in the event of breach. These clauses are often enforceable because it is very difficult to ascertain the damages that are actually incurred by delay of a construction project.
Practical Advice for Use of Liquidated Damages Clauses
First and foremost, it is far more cost efficient and effective for the contracting parties to involve transactional attorneys at the time of the formation of a contract, not only to determine whether a liquidated damages clause makes sense at all, but also to negotiate the contents and form of the clause. It is far less cost efficient to employ litigation attorneys to argue in court over the enforceability and interpretation of such clauses.
With that general principle in mind, there are several matters that parties should consider when deciding whether to agree to a liquidated damages clause:
- The nature of the contract;
- The possible deterrent effects of a liquidated damages clause;
- The length of the contract term;
- The type of performance required under the contract;
- The uncertainties and contingencies required for a full performance under the contract;
- The ability to ascertain the specific amount of monetary damages resulting from a breach;
- The reasonableness of any liquidated damages amount agreed to; and,
- The possible deterrent effects of the clause.
Liquidated damages clauses can be an extremely effective way of preserving contractual relationships and streamlining any litigation that results from those relationships. However, when used incorrectly or drafted improperly, liquidated damages clauses can create more harm than good. As a result, parties must carefully consider many issues before determining that a liquidated damages clause is appropriate for inclusion in any contract.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.