Liquidated damages are amounts to be paid in the event of a breach that are calculated during the formation of the contract. Liquidated damage clauses are beneficial in cases where the injury is difficult to ascertain. In addition, assessing damages at the outset of the contract can incentivize the parties to perform their obligations under the contract. But a liquidated damages clause that is not reasonably commensurate to the injury suffered by the innocent party may be deemed a penalty clause. If a court construes the clause as a penalty on the breaching party, it will be deemed unenforceable.

What is considered a penalty clause in contract law? Simply put, a penalty clause is characterized by an excessively large damages award that is not proportionate to the damages emanating from the breach. It is regarded as contradictory to public policy because it functions as “punishment” for a contractual breach rather than a means of remedying a violation in order to make the injured party “whole” once again.

In California, liquidated damages clauses in commercial, non-consumer contracts are considered presumptively valid unless the challenging party can establish that the clause was unreasonable under the circumstances.  In other words, the court will uphold the provision so long as (i) it is a good faith attempt to estimate the damages that might ensue from a breach of the contract and (ii) evaluating actual damages at the time the agreement was made is difficult. California courts have invalidated liquidated damages provisions that are intended only to enforce compliance with the agreement rather than to provide compensation to the party who suffered a breach.

In many states, including California., the central issue is evaluating what the term “unreasonable” means for a liquidated damages clause. Courts will generally examine a range of factors that existed at the time the contract was signed including: the bargaining position of each of the parties, the likelihood that proving actual damages would be difficult, whether the parties had adequate representation, and the prospect of showing causation under the facts. Courts may consider other facts as well and decide how much emphasis each of these factors bear in its assessment.

Contact Shane Coons at 949-333-0900 or visit his website at www.ShaneCoonsLaw.com to find out more about his practice.