difference between liquidated damages and penalty

Your business relies on commercial relationships to support its operations and to sell its goods and services. Whether that relationship takes the form of an order for goods from a customer or a set of software services from an IT specialist, it is usually memorialized in a written contract.

You are entitled to rely on these executed contracts, and being able to rely on contracts allows you to responsibly allocate business resources and make future plans for growth. 

However, if your commercial partner breaches the contract, it disrupts your plans and you suffer damage. Often the disruption and damage are extremely upsetting, and your first instinct may be to find a way to punish the breaching party. That instinct is quick, easy, and to the point. However, American commercial law does not usually allow for penalties in breach of contract matters.  

But there are narrow circumstances where the parties can agree on damages in advance of a breach. The law calls this agreed provision “liquidated damages.” Here, we discuss the narrow road you need to take to include an enforceable liquidated damages clause in your contracts and the pitfalls of their alter-egos: penalty clauses.

“Business owners and managers are sometimes surprised to learn that there are legal limits on the ability to agree in advance to a penalty for failure to perform a contract. It’s a very complicated aspect of contract law.”

Ashley Brewer, Business Contracts Attorney

The Purpose of Contract Law

Unlike criminal law, which focuses on punishment and retribution, civil commercial law focuses on making injured parties whole again. In other words, contract law asks, Where would the injured party be if there was no breach of contract? Consequently, courts reject any perceived movement to punish a breaching party in a contract case beyond actual damages. This means that civil actions for breach of contract focus on establishing the facts to measure damages. Moreover, those damages must be actual and ascertainable; they cannot be speculative and punitive. 

Courts spend a great deal of time in lawsuits establishing facts to properly measure actual damages. But sometimes there are circumstances when contracting parties cannot effectively ascertain or predict what damages may result in the event of a contract breach. The unknown may be so risky that the parties may be reluctant to enter into a contract at all. In these narrow circumstances, courts have upheld liquidated damages clauses.

Liquidated damages clauses allow parties in those circumstances to enter into a contract because they can measure the damages in advance. The problem is that courts never enforce penalty clauses, the close cousin to liquidated damages clauses. Thus, drafting enforceable liquidated damages clauses requires great skill; the difference between liquidated damages and a penalty is very fine. Courts are wary of mistakenly upholding a liquidated damages clause when in fact it is nothing more than a penalty clause. Therefore, drafting an enforceable liquidated damages clause is an exercise in high legal skill

The Definition and Structure of a Liquidated Damages Clause

A valid liquidated damages clause measures solely the damages for breach that are otherwise unascertainable. Further, ascertainability must exist at the time of contract execution. Florida law holds that a valid liquidated damages clause exists when:

  • Damages for breach are not readily ascertainable at the time the contract was entered into;
  • The amount in the clause is not grossly disproportionate from reasonably expected damages arising from the breach; and
  • The clause is not deemed a penalty by the breaching party at the time the contract was entered into.

Further, there is another key to enforceability. Courts will not enforce liquidated damages clauses that are part of an option of remedies. For example, having a choice between liquidated damages or suing is not an enforceable liquidated damages clause because the choice shows the ability to ascertain damages (i.e., the option to sue) and thus removes the need for the liquidated damages clause. Therefore, a contract’s liquidated damages clause must be the sole and exclusive remedy available to the non-breaching party. 

To give a practical—and common—example of an enforceable liquidated damages clause let’s focus on a Florida construction contract. The parties can provide for damages of $500 per day for any delay by one party to complete construction of a project. Provided it is fair and reasonable, it is appropriate to enforce a liquidated damages clause of $500 per day. The underlying premise is that predicting damages for delay in construction is difficult, if not impossible, and thus a fixed amount—based on a reasonable estimate (again $500 per day)—is appropriate as liquidated damages. However, such a clause can slip into a penalty if you are not extremely careful in drafting it.

What Is an Unenforceable Penalty Clause?

To begin, when damages can be reasonably ascertained at the time the parties enter into a contract, there is no need for a liquidated damages clause. In those cases, the remedy is to sue for actual damages. As well, any provision in a contract that acts to punish the breaching party for non-performance (i.e., used as a threat to induce performance), and which does not bear a reasonable relationship to the potential damages, is unenforceable. Finally, consider whether the proposed liquidated damages clause (and its dollar amount) “shocks the conscience” when applied to the breach. Such a reaction indicates no reasonable relationship to the damage suffered by the non-breaching party.

As an example of a penalty clause, consider an extremely high daily damage rate in the above construction contract example (i.e., $10,000/day as opposed to $500/day). Another example is a clause that provides for a payment of $1,000 if a party fails to deliver goods by a certain date. In that example, there may be two issues of unenforceability.  The first is that the dollar amount may be too high. Second, but more importantly, if there is a failure to deliver goods, the damages can be reasonably measured (i.e., you can calculate your lost profits within reason).

All this raises another important point concerning the use of liquidated damages clauses.  You cannot justify using a liquidated damages clause just because it’s easier or more convenient than the remedy of suing for actual damages (i.e., damages measured through a trial). A liquidated damages clause is not an end-run around civil litigation.

Common Industries for Liquidated Damages vs. Penalty

Some commercial activities and industries lend themselves to using liquidated damages clauses given the nature of the services and goods provided. We have already mentioned the construction industry. In construction, failure to complete building projects or phases of building projects can create delays and chain reactions in timing that are almost impossible to anticipate. And it’s unfeasible to measure the resulting damage. As such, liquidated damages are often very appropriate. The sale of commercial and residential real estate is also of a nature where damages may be difficult to ascertain. In that case, when the buyer fails to perform, the seller must relist the property. The damages are difficult to ascertain after a property, having been off the market and under contract, re-enters the market. Thus, liquidated damages are proper.

Let BrewerLong Thread the Needle 

Don’t take the difference between liquidated damages and a penalty lightly. In narrow commercial contexts, a liquidated damages clause is both necessary and appropriate. However, to get it right in these extremely narrow circumstances, you need skilled and effective legal counsel. The attorneys at BrewerLong have been advising business clients on their contracts for decades. Allow us to help you craft the ideal liquidated damages clause for your commercial contracts. Contact us today to see what we can do for your business.

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