Liquidated damages are often used to provide some certainty to a future aggrieved party and to encourage performance of the contract by both parties. It is generally employed when the calculation of actual damages upon execution of the contract is onerous or impractical. But the enforceability of such a clause could be compromised if the court determines that it is, in fact, a penalty clause. Thus, a liquidated damages clause in a contract should be drafted as a means of equitably compensating the non-breaching party, rather than as a penalty on the defaulting party.
In California, courts historically refused to enforce liquidated damages and regarded them as inherently invalid until the late 1970’s. This presumption changed in 1977 when California established that liquidated damages in commercial contracts should be treated as valid and enforceable. The rule provided that, in most cases, a liquidated damages provision is effective in the event of a breach unless the party against whom it is enforced can demonstrate that it was unreasonable at the time it was drafted. Thus, the presumption of validity in non-consumer contracts remains subject to the exception that the liquidation damages provision cannot be implemented for the sole purpose of compelling performance of the contract. The clause must be drafted for the purpose of reimbursing the aggrieved party for damages, particularly when it is difficult to determine damages. The penalty should represent a fair and reasonable approximation of the damages that might be incurred by the innocent party as a result of a breach.
But what constitutes a “reasonable” liquidated damages provision? The California Supreme Court has concluded that a liquidated damages clause is considered unenforceable if it “bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.” In evaluating whether the clause meets the standard of reasonableness, the courts may consider any of the following: (i) the extent of anticipated harm that could have resulted from a breach of the contract, (ii) whether the parties had determined that establishing actual damages would be difficult, (iii) the relative bargaining positions of the parties, and (iv) whether the parties had adequate representation. In addition, in real property transactions, a liquidated damages provision upon buyer’s default must be individually agreed to (as denoted by separate signatures) by both parties.
Contact Shane Coons at 949-333-0900 or visit his website at www.ShaneCoonsLaw.com to find out more about his practice.