Laurin: Liquidated damages provisions: enforceable or a penalty?

By Sam Laurin

Laurin

Liquidated damages provisions are common in real estate and construction contracts. When litigating the enforceability of liquidated damages provisions, the issue is almost always whether the provision is in reality an unenforceable penalty.

The Indiana Supreme Court’s most thorough analysis of liquidated damages is contained in Time Warner Entertainment Co. L.P. v. Whiteman, 802 N.E.2d 866 (Ind. 2004). In Whiteman, the Supreme Court defined liquidated damages as a “specific sum of money that has been expressly stipulated by the parties to a contract as to the amount of damages to be recovered by one party for a breach of the agreement, by the other, whether it exceeds or falls short of actual damages.” Id. at 893. There are three principal rules used by the courts to determine the enforceability of a liquidated damages provision. First is the intention of the parties and the reasonableness of the stipulation under the circumstance of the contract. Second, if there is a breach and the resulting damages would be uncertain and difficult to ascertain, and the stipulated sum is fair compensation for the breach, then the provision is enforceable. Third, if the liquidated damages sum is grossly disproportionate to the loss and in reality is a penalty, then the provision is unenforceable. (Id. at 894 citing Olcott Int’l & Co. v. Micro Database Sys., 793 N.E.2d 1063, 1077 (Ind. Ct. App. 2003)).

The decision in Harbours Condominium Ass’n, Inc. v. Hudson, 852 N.E.2d 985 (Ind. Ct. App. 2006) is very instructive. The greatly simplified facts of Harbours Condominiums involved a condominium assessment that was not paid for a considerable period of time. The condominium association sought to recover unpaid assessments and late fees of $74,154.24 (late fees of $25 for each nonpayment and $5 a day until paid, as well as attorney fees). The trial court awarded a judgment against the condominium owner for $799.12 for unpaid assessments and $7,117.24 in actual costs of collection and attorney fees. The condominium association appealed the trial court’s refusal to grant a judgment in the total amount of $74,154.24 for all of its claimed late fees. The Indiana Court of Appeals found that the late fees were a penalty for two reasons. First, the condominium association’s actual damages were not uncertain or difficult to ascertain; the evidence allowed the trial court to determine actual damages to the penny. Second, the court held that the $74,154.24 was a penalty because the amount owed was only $799.12. This second reason merits further analysis.

A threshold question is at what point in time should a court look to determine if a liquidated damages amount is a penalty? Cases from other jurisdictions disagree whether the reasonableness of the liquidated damages is examined at the “front end” (i.e., at the time the contract was entered into: e.g. Boone Coleman Construction Com., Inc. v. Village of Piketon, 2016 WL 744304) or retroactively (i.e., at the time the breach occurred: e.g. O’Brian v. Langley School, 507 S.E.2d 863 (Va. 1998).). The majority rule appears to be that reasonableness is determined at the “front end.” Boone Coleman, 2016 WL at 4-5. The court’s comparison in Harbours Condominium of the liquidated damages claimed and the actual damage was certainly a retroactive analysis. While that comparison is eminently reasonable under the facts, is a retroactive review appropriate given the criteria to analyze the enforceability of a liquidated damages provision? The court in Harbours Condominiums acknowledged the difficulty of dealing with these issues: “We acknowledge some contradiction within the rules that define how to distinguish liquidated damages from a penalty.” Id. at 993. By definition, liquidated damages are the parties’ attempt to predetermine a measure of damages at the time of contracting (i.e. the intention of the parties). If one of the rules is to ascertain the parties’ intentions, then an examination of the reasonableness should be done at the “front end.” In Boone Coleman, the Ohio Supreme Court characterized as “myopic” the Ohio Court of Appeals finding that liquidated damages was a penalty because liquidated damages assessed on a construction contract was 40 percent of the total construction contract price. Id. at 6.

The Indiana Supreme Court in Whiteman also raised the issue of enforcing the parties’ intentions when it stated in dicta that: “We are left with some unease over any decision where what appears to be the freely bargained agreements of the parties are set aside. Fixing the respective rights and expectations of the parties as to damages makes economic and commercial sense. Enforcing such provisions would seem to conform to this Court’s long-standing recognition of the freedom of parties to enter into contracts and our presumption that contracts represent the freely-bargained agreement of the parties.”

Whiteman and Harbours Condominium provide some takeaways for lawyers drafting liquidated damages in commercial contracts. The contract should have an acknowledgment by both parties that the liquidated damages provision represents a reasonable estimate of the damages at the time of contracting, that the damages would be difficult to ascertain if there is a breach, and the liquidated damages clause is not intended to be a penalty. This language should address a concern that a court could apply a retroactive view, but additional language also could be added showing that the parties agree that reasonableness is only to be considered at the time of contracting. It might also make sense depending on the circumstances to describe the category of damages that might be incurred in the event of breach and have both parties acknowledge that they are in fact not easily ascertained. This may prevent a party from arguing later that the damage amount was simply a unilateral number developed by the party seeking to enforce the provision. Lastly, the standard language that neither party is deemed the drafter of the contract will also increase the chance of enforceability. Whiteman, 802 N.E.2d at 894 (if a liquidated damages provision is ambiguous then characterizing it as a penalty will be favored).•

• Sam Laurin is a partner of Bose McKinney & Evans LLP, where he serves as the chair of the firm’s litigation and construction law groups. The opinions expressed are those of the author.