[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:
- 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
- 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.
This article may be freely reprinted or distributed in its entirety in any e-zine, newsletter, blog or website. The author’s name, bio and website links must remain intact and be included with every reproduction. View general information about this license; or view detailed legal information about this license.