“Liquidated damages” may sound like the name of a long-lost Nirvana b-side, but instead they refer to clauses often buried towards the end of a long contract which purport to state what financial compensation one party must pay another in the event of the breach of a contract.
While liquidated damages have a very long history of appearing in contracts – after all, the whole purpose of a contract is to set out ahead of time what each party should do in the future, and this clause takes it even further to say what each party should do if one doesn’t actually do what is in the rest of the contract – but they also have a very long history of being invalidated by courts.
Why Courts Are Suspicious of Liquidated Damages Clauses
Why do courts so often invalidate liquidated damages clauses? In one respect, courts don’t love it when one party in a contract decides it will take the place of the court in determining what happens in the case of a breach.
But, relatedly, courts look on liquidated damages clause with suspicion, as they can be used as a coercive tool to force a less powerful party to follow through with an obligation against its will because there is a huge penalty hanging over their head, which might indeed be far greater than what a court would award in a breach of contract action.
Liquidated Damages Clauses in CA Commercial Real Estate Contracts
California courts, in particular, are notorious for invalidating contract clauses that, by definition, both parties agreed to, e.g. non-compete clauses in employment agreements. California courts have indeed taken a similar approach to liquidation clauses over the years.
That said, California courts are willing to enforce a liquidated damages provision where it is not reasonable, pursuant to the California civil procedure code, which states, “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”
This brings up the question of what is and what is not reasonable. In essence, courts find liquidated damages clauses reasonable where they are actually based on a reasonable attempt to determine what the financial injury would be to the non-breaching party in the case of a breach by the other party. This means looking at the actual money lost by the non-breaching party, as well as associated administrative costs, e.g. the cost associated with finding a similar property, buyer, tenant, etc., to replace the breaching party.
Where courts will not validate such clauses is where they go far beyond what the actual costs of the breach would be and appear to be more of a penalty for the potentially breaching party which induces them not to breach. For example, if the cost of the breach for the non-breaching party would be approximately $50,000 but the liquidated damages clause asks for a $500,000 payment, this would appear to be more of a penalty than a reasonable estimate of losses, and thus would be more likely to be invalidated by a court.
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