• Contract Penalties Not Allowed

Contracts: Penalties Not Allowed

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by Noel Bagwell
for Executive Legal Professionals, PLLC

September 5, 2014

Reading Contracts: Liquidated Damages

Many people find it confusing that courts will often refuse to enforce provisions of contracts deemed “penalties.” Seminal jurist, legal theorist, and economist Richard Posner called the Penalty Doctrine of the common law of contracts “a major unexplained puzzle in the economic theory of the common law.” (Richard A. Posner, Some Uses and Abuses of Economics in Law, 46 U. Chi. L. Rev. 281 (1979) at 290.) Whether one agrees with—or even understands—the Penalty Doctrine is irrelevant outside the academic sphere. What matters is: penalties in contracts are unenforceable.

Does the unenforceability of penalty clauses mean the incentives we build into contracts must be all carrot and no stick? No. The law recognizes, and courts will enforce contract provisions requiring the payment of what are called “liquidated damages.” Liquidated Damages are a variety of actual damages. (Wex) “Actual damages” means:

“Money awarded to compensate for actual losses (also called “compensatory damages”).  The amount awarded is based on the proven harm, loss, or injury suffered by the plaintiff.  This award does not include punitive damages, which may be awarded when the defendant’s actions are especially reckless or malicious.” (Wex)

The First Restatement of Contracts § 339(1) provides, “the damage agreement is not enforceable unless it was a reasonable forecast of the harm and the harm is difficult to estimate.” “It is possible to interpret this rule as measuring the reasonableness at either the time of contracting or the time of breach, opening up the possibility that damages that were reasonable

[prior to the breach] might be held to be a penalty if they were excessive [after the breach]. … Damages that are below the actual loss [after the fact of breach of contract and suffering of harm by the non-breaching party] are usually enforced.” (Samuel A. Reah, Jr., Efficiency Implications of Penalties and Liquidated Damages, 13 J. Legal Stud. 147 (1984).)

In order to ensure one is correctly drafting the provisions of a contract pertaining to incentives that comprise elements akin to a “stick,” as opposed to those comprising elements analogous to a “carrot,” the drafter must be careful to ensure that he can forecast with reasonable confidence the following things:

  1. The specific harm—or, at least, the specific kind of harm—that, by his breach, the breaching party is most likely to cause to the non-breaching party; and
  2. The pecuniary value of the loss to the non-breaching party of the benefit of the bargain proximately caused by the breaching party’s breach.

“Most courts judge the enforceability of liquidated damages clauses as of the time of contract formation. In Lind Building Corp v. Pacific Bellevue Developments, the court created a “no actual injury” defense to enforcement of liquidated damages clauses by assessing validity as of the time of trial.” (James Arthur Weisfield, ‘Keep the Change!’: A Critique of the No Actual Injury Defense to Liquidated Damages, 65 Wash. L. Rev. 977 (1990).) Essentially, the “no actual injury” defense is exactly what one would expect–a defense that says, no harm, no foul. At least, prior to 1989, “courts have not been consistent on this point. The federal courts have enforced penalty clauses against those with government contracts if the damages were reasonable ex ante, regardless of actual damages.” (Reah; see also United States v. Bethlehem Steel Co., 205 U.S. 105 (1907).)

A good contract drafter will avoid uncertainty and ambiguity in the drafting of liquidated damages clauses, and will expressly adopt in the contract language conservatively reasonable ex ante estimates of liquidated damages, tied to specific foreseeable harms likely to be caused in the event of a breach. When reading a contract’s liquidated damages clause(s), keep these points in mind, and negotiate changes to liquidated damages clauses that fail to meet the above criteria before executing the contract.

As one might expect, this author cannot in good conscience forego the recommendation that you have any contract reviewed by experienced legal counsel before signing it. If you need contract drafting or review services, you may contact Executive Legal Professionals at +1.615.669.6566 or online at www.ExecutiveLP.com. Executive Legal Professionals offers contract drafting and review services to businesses for flat fees, and offers packages of ongoing legal services to business on a subscription basis.

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