As we have pointed out, in our article “Contracts: Penalties Not Allowed”, “one of the main anomalies in the economic explanation of common law is the rule against penalty clauses in contracts.” (Rubin, 1981) The best explanation I have read for why penalty clauses in contracts are not enforceable is in the cited article by Paul Rubin. His answer is somewhat technical, but it boils down to this:
There is a strong presumption that principles of commercial and contract law–especially long-established principles–are economically efficient. The rule against penalty clauses is such an established rule; therefore, the presumption must be that it is economically efficient. But any voluntary agreement between two parties can also be assumed to be efficient with respect to the two parties. …
To reconcile this paradox it may be argued that, while penalty clauses are efficient vis-à-vis the two parties involved, their effects on third parties serve to make them, net, inefficient. In particular, contracts with penalty clauses are often not even expectedly self-enforcing, in the sense defined
[earlier in the article]. When contracts have such clauses, parties may expect attempted breach and consequent litigation even if circumstances do not change.
In summary, even if it were efficient, with respect to the parties to a contract, to enforce penalty clauses in contracts, the effects of the dispute, particularly the effect of of having to resort to resolving the dispute in the Courts, impose on third parties–people or entities who are not parties to the contract–costs which have no corollary benefit. Therefore, penalty clauses are not economically efficient. This is why penalty clauses are not and should not be enforceable.
That’s not to say the parties are without a remedy for breach of contract–far from it! In fact, liquidated damages are the norm; sometimes, even specific performance can be required to cure a breach of contract.
Why Liquidated Damages Are Allowed In Contracts
Liquidated damages are “‘damages the amount of which has been determined by anticipatory agreement between the parties;’ or, ‘damages for a specific sum, stipulated or agreed upon as part of a contract, as the amount to be paid to a party who alleges and proves a breach of it.'” (Garland, 1901) Liquidated damages are generally confined to the actual pecuniary damages suffered by the party against whom a breach of contract is alleged. In other words, “no harm, no foul.”
Where parties can agree that, if a party does (or neglects to do) a specific thing, in respect to which the amount of the damages are uncertain, a certain sum must be paid to another party if that thing is not done (or done); there the aforementioned sum may properly be treated as liquidated damages, not as a penalty, provided the terms of the contract do not indicate or strongly suggest a different intention of the parties. Whether or not actual damages are ascertainable, where it appears, from the circumstances or the nature of the case, that the sum upon which the parties agree has been fairly calculated and is not, on its face, grossly excessive or unjust, the sum will be treated as liquidated damages.
This is the case, because liquidated damages exist to put the parties in the respective pecuniary positions in which they would have been, had a breach never occurred, without necessarily effecting a rescission of the contract. If the benefit, to me, of a contractual bargain is, for example, $25,000; and the other party to the contract breaches the agreement, and I lose that benefit, the other party should pay me $25,000, because that is the value of the benefit I would have obtained but for their breach of contract.
Three Tips for Effectively Using Liquidated Damages Clauses
1. In (each of) the Contract’s liquidated damages clause(s), describe the reason for assigning a specific value to a particular breach.
The literature on penalties and liquidated damages–legal treatises and cases, going back to the mid-19th century and beyond, and nearly every noteworthy published legal opinion since–is very clear that the intention of the parties, with respect to any liquidated damages clause(s), should be to agree upon a method for calculating liquidated damages, to agree upon the final amount of any liquidated damages, and not to attempt to mask a penalty behind a description of liquidated damages. “Calling a sum liquidated damages will not change its character as a penalty, if upon the true construction of the instrument, it must be deemed to be a penalty.” (Story, 1856)
2. Describe the method by which the parties calculated the amount of liquidated damages. Make sure you expressly state that the parties agreed to use that method. Consider including a concise statement of the reason why the parties used that method.
If a court can examine, and follow the logic of, the methodology used for calculating a certain sum of liquidated damages, its ability to do so will lend credibility to such a methodology, presuming it is appropriate for the expressly stated purpose (see the previous point). If your methodology for determining the sum of liquidated damages is the right tool for the job, a court is likely to observe that it is such, and the court’s observation will support a party’s contention that the methodology resulted in a reasonable, fair, and just sum of liquidated damages, which the court can uphold.
3. Expressly include, as liquidated damages, attorney’s fees for breaches of contract (an abrogation of The American Rule), as well as any other anticipatory (but not consequential) damages.
Usually, consequential damages, while available in tort, are not available in contract law. Attorney’s fees, however, can be considered liquidated damages. The American Rule is that each party pays its own attorney’s fees. You must expressly abrogate The American Rule, if you want to have any hope of recovering attorney’s fees in a breach of contract case, and it’s always a good idea to expressly state the (obvious) fact that such attorney’s fees are to be considered liquidated damages.
These tips are generally more useful to attorneys and other legal professionals involved in the process of drafting contracts. Only a qualified legal professional–nearly always an attorney–should have the final word on whether a contract is well-drafted for its intended purpose. Therefore, a business decision-maker is always well-served to employ an attorney, at a minimum, to review the contracts he or she intends to use, before putting them in front of anyone else for execution.
This article addresses its subject matter in very broad, general terms. There are exceptions to most of the points made, herein. Only a qualified legal professional is likely to be aware of such exceptions. So, business decision-makers would be well served to discuss the content of this article with a licensed attorney before taking any business or legal action based, in whole or in part, on any information contained herein.
The friendly, helpful attorneys at Executive Legal Professionals, PLLC would love to speak with you, if you have any questions or concerns about drafting liquidated damages clauses in your business’s contracts, or about interpreting liquidated damages clauses in contracts your business uses or encounters. It’s very easy to reach an ExecutiveLP™ attorney; just visit our Contact page, and fill out the contact form. An attorney will reply to your query in a timely fashion. Thanks for reading!
Rubin, P. H.. (1981). Unenforceable Contracts: Penalty Clauses and Specific Performance. The Journal of Legal Studies, 10(2), 237–247. Retrieved from http://www.jstor.org/stable/723978
Garland D.S., et al., eds. (1901). Liquidated Damages. The American and English Encyclopaedia of Law (2d ed.), 395. (citing Bouv. L. Dict. Volume XIX.)
Story, W.W. (1856). Penalties and Liquidated Damages. Treatise on the Law of Contracts (4th ed.), 693.