“As Liquidated Damages and Not As a Penalty”

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.

About the author

Ken Adams is the leading authority on how to say clearly whatever you want to say in a contract. He’s author of A Manual of Style for Contract Drafting, and he offers online and in-person training around the world. He’s also chief content officer of LegalSifter, Inc., a company that combines artificial intelligence and expertise to assist with review of contracts.