Liquidated Damage Provisions – A Good Idea or an Unenforceable Penalty?

Construction contracts often contain a provision for a stipulated or “liquidated” damage amount in the event of specified contract breaches. These provisions can be an effective tool to recover losses that otherwise may go uncompensated because they cannot be proven or because the damages are not recoverable under an ordinary contract.¹ However, courts generally will not enforce a liquidated damage provision that is seen as a “penalty” unrelated to any anticipated or actual loss.² The question, then, is whether a particular contract provision will be interpreted as an enforceable liquidated damages provision or an unenforceable contractual penalty.

General Enforceability Standards

In determining whether a liquidated damage provision is enforceable, a court will look at whether the amount of the liquidated damage is reasonable in light of either: (1) the anticipated loss at the time the contract was entered into; or (2) the actual damages caused by the breach.³ The court may also look at how difficult it would be to prove the actual amount of the loss due to the breach that triggered the liquidated damage provision. If it fixes unreasonably large liquidated damages, the provision will likely be unenforceable on grounds of public policy as a penalty.⁴

There are also varying views between federal and state case law on the topic. While there are always exceptions, federal case law generally finds that liquidated damage clauses are not disfavored.⁵ An early United States Supreme Court decision even said that such provisions in contracts entered into between parties should be examined “with candor, if not with favor.”⁶ State law, on the other hand, varies from state to state, but often “breaks ties” in favor of finding liquidated damages to be a penalty.⁷

Finally, even if a liquidated damage provision is found to be an unenforceable penalty, a court may still examine whether the provision is, in fact, an unenforceable liquidated damage or if, instead, it is an enforceable alternative promise.⁸ For a party seeking to enforce such a provision, it would be wise to raise such an argument if there is a legitimate basis to assert that the provision in question — even if determined to be a penalty — is actually an enforceable alternative promise between the contracting parties. For example, if the contract requires a party to pay $10,000 in the case of a breach for failure to perform, that party could argue that the provision is actually a promise to render performance or, in the alternative, to pay $10,000. Courts have used this concept of alternative performances to sustain “take or pay” contracts under which natural gas pipeline companies agree to pay for a minimum quantity of gas (whether they take it or not).⁹

How Much is Too Much (or Not Enough)?

There is no bright-line rule as to what amount of liquidated damages may be deemed reasonable. However, a liquidated damages clause is more likely to be found valid if the amount specified was reasonable at the time of contracting or, alternatively, if the amount specified is reasonable in light of the actual loss caused by the breach.¹⁰ Stated differently, there must be some link between the amount of the liquidated damage and either the anticipated loss at the time of contracting, or the actual loss suffered by the non-breaching party. For example, one court found that liquidated damages of $500 per day was an unenforceable penalty where the amount was not based on the owner’s expected damages, but instead was simply a number that was chosen as a big enough “stick” to get the job completed on time.¹¹ However, in another case, a court upheld a $70,000 liquidated damage award in a dispute over a state highway contract, even though the actual damages were $20,000, finding that damages for delayed completion of a public road were difficult to quantify.¹²

On the other side of the coin, courts are also wary to enforce a liquidated damage clause that significantly undercompensates for a loss.¹³ Such provisions may either be analyzed under the “penalty” analysis discussed above, or as an improper limitation of liability, cloaked as a liquidated damage provision.¹⁴ Either way, the takeaway is the same: there must be a reasonable relationship between the liquidated damage amount and either the anticipated or actual loss.

¹ 6 Bruner & O'Connor On Construction Law § 19:52.
² 6 Bruner & O'Connor On Construction Law § 19:52.
³ 6 Bruner & O'Connor On Construction Law § 19:52.
⁴ 6 Bruner & O'Connor On Construction Law § 19:52.
⁵ 6 Bruner & O'Connor On Construction Law § 19:66.
⁶ 6 Bruner & O'Connor On Construction Law § 19:66.
⁷ 6 Bruner & O'Connor On Construction Law § 19:66.
⁸ 6 Bruner & O'Connor On Construction Law § 19:66.
⁹ 6 Bruner & O'Connor On Construction Law § 19:66.
¹⁰ 6 Bruner & O'Connor On Construction Law § 19:52.
¹¹ 6 Bruner & O'Connor On Construction Law § 19:52.
¹² 6 Bruner & O'Connor On Construction Law § 19:52.
¹³ 6 Bruner & O'Connor on Construction Law § 19:65.
¹⁴ 6 Bruner & O'Connor Construction Law § 19:65.