Contract parties are free to structure their relations as they see fit, but within limits set by statute or by the courts. That raises the question, does it make sense to state in a contract that you’re complying with a given legal requirement?
After all, as a general matter courts won’t take at face value a contract statement to the effect that, for example, a given provision complies with public policy. Instead, a court will draw its own conclusion.
To explore this, I considered the phrase as liquidated damages and not as a penalty, which obviously enough occurs in provisions in which the parties, instead of having actual damages determined in the event of a dispute, specify what damages a party is to pay on breach of a given obligation.
By way of background, the following is from 24 Williston on Contracts § 65:1 (4th ed.):
Under the fundamental principle of freedom of contract, the parties to a contract have a broad right to stipulate in their agreement the amount of damages recoverable in the event of a breach, and the courts will generally enforce such an agreement, so long as the amount agreed upon is not unconscionable, is not determined to be an illegal penalty, and is not otherwise violative of public policy.
It is generally agreed that a liquidated damages provision does not violate public policy when, at the time the parties enter into the contract containing the clause, the circumstances are such that the actual damages likely to flow from a subsequent breach would be difficult for the parties to estimate or for the nonbreaching party to prove, and the sum agreed upon is designed merely to compensate the nonbreacher for the other party’s failure to perform. On the other hand, a liquidated damages provision will be held to violate public policy, and hence will not be enforced, when it is intended to punish, or has the effect of punishing, a party for breaching the contract, or when there is a large disparity between the amount payable under the provision and the actual damages likely to be caused by a breach, so that it in effect seeks to coerce performance of the underlying agreement by penalizing non-performance and making a breach prohibitively and unreasonably costly. In such cases the clause, rather than establishing damages that approximate or are proportional to the harm likely to flow from a particular breach, actually constitutes a penalty, and, since penal clauses are generally unenforceable, provisions having this effect are declared invalid; and this is generally true even where the provision is negotiated in good faith, at arms’ length and between parties of equal bargaining power.
But if the parties say that a given payment constitutes liquidated damages and not a penalty, doesn’t that settle it? Apparently not. According to Restatement (Second) of Contracts § 356 cmt. c (1981), “Neither the parties’ actual intention as to its validity nor their characterization of the term as one for liquidated damages or a penalty is significant in determining whether the term is valid.”
So instead of saying “Acme shall pay Widgetco $3,000,000, as liquidated damages and not as a penalty,” you might as well just say “Acme shall pay Widgetco $3,000,000,” right? Well, it’s not as simple as that, because some caselaw contradicts the Restatement. E. H. Schopflocher, Provision for Liquidated Damages in Contract for Sale of Goods, 138 A.L.R. 594 (1942), says, “courts have given varying weight to the language used by the parties.” It goes on to cite various court opinions, including Ludlow Valve Mfg. Co. v. City of Chicago, 181 Ill. App. 388 (1913), in which the court said, “The fact that parties fix a sum to be paid in case of a breach of the contract and call that sum ‘liquidated damages’ is not conclusive, but is one of the circumstances tending to prove the actual intent of the parties.” Recent Illinois cases have cited the Ludlow case, so it’s still good law.
So if at least some courts pay some attention to how a contract characterizes a payment to be made on breach of a given obligation, drafters would be rash to omit any such characterization.
But I recommend that you do more than just trot out as liquidated damages and not as a penalty. It’s sufficiently rote and terse as to constitute jargon. Because drafters and their clients don’t give it much thought, courts would be entitled not to pay much attention to it either.
Here’s a more meaningful way of saying the same thing:
Acme acknowledges that the actual damages likely to result from breach of this section X are difficult to estimate on the date of this agreement and would be difficult for Widgetco to prove. The parties intend that Acme’s payment of the Liquidated Damages Amount would serve to compensate Widgetco for any breach by Acme of its obligations under this section X, and they do not intend for it to serve as punishment for any such breach by Acme.
By the way, is this an issue outside the U.S.?
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In the next week or so I’ll look at another example of language drafters use to signal that a contract complies with a public-policy requirement.
Perhaps the contract should list the facts showing why liquidated damages are appropriate. For example, the Comcast Subscriber Agreement has the following:
“Comcast does not anticipate that you will fail to pay for the Services on a timely basis, and we do not extend credit to customers. Any fees, charges, and assessments due to late payment or nonpayment are liquidated damages intended to be a reasonable advance estimate of our costs resulting from late payments and non-payments. These costs will be difficult to calculate or to predict when we set such fees, charges, and assessments, because we cannot know in advance: (a) whether you will pay for the Services on a timely basis, if ever; (b) if you do pay late, when you will actually pay; and (c) what costs we will incur because of your late payment or non-payment. “
Gus: Good idea. Ken
Ken, to answer your question, yes this is an issue outside the US, at least in England and Wales. The following, typical language is seen:
If X breaches clause [ ], X shall pay Y the sum of £[ ] by way of liquidated damages. The parties acknowledge and agree that such sum is a genuine pre-estimate of Y’s anticipated loss resulting from such a breach.
The “genuine pre-estimate of anticipated loss” language comes from English case law on whether a payment is a liquidated damages clause or an unlawful penalty. I think the wording is rather self-serving and unlikely to influence a judge, but it probably does no harm, so is often included.
There is plenty of English case law on this subject and it is not straightforward to structure a liquidated damages payment. For example, it may be better to have a range of payments for different situations, rather than a one-size-fits-all payment.
I usually advise clients contemplating such a clause to keep a file note of how they have pre-estimated the amount, in case of future dispute.
I don’t believe that this kind of clause has any formal legal effect. But it can’t be easy for a party, having signed a contract that says the amount is a genuine pre-estimate of loss, to stand up in court and argue that the amount isn’t, after all, a genuine pre-estimate of loss. I think it must make it much easier for the judge to conclude that the estimate was genuine, as per the Ludlow case.
I expect it may (or at least should) have little effect if included in standard terms though, especially in consumer contracts.
Canadian law, at least Alberta law, is quite similar – the leading case being Lozcal Holdings Ltd. v. Brassos Development Ltd., 111 D.L.R. (3d) 598.
What are your thoughts on distinguishing between a payment as a deposit (security for performance) and as liquidated damages (an estimate of damages likely incurred)?
Ken, assuming the LD clause meets the elements under UCC 2-718(1) for enforceability, but allows the non-breaching the right to elect between (x) the LDs and (y) actual damages under a formula in the agreement, such that the LD clause would be a penalty under common law and therefore unenforceable, is the clause also unenforceable as a penalty under UCC Article 2?
Excuse me if I set this question aside for now. It would require more attention than I can bring to bear at the moment.