There is nothing more tempting in an executory contract than to seek to stick it to the other contracting party through a liquidated damages clause in the event of a failure to perform. Greed, however, can result in tunnel vision. The risk of reaching too far could be the invalidation of the liquidated damages clause. The seminal inquiry is whether the liquidated damages clause is a penalty for non-performance or is it a reasonable measure of the damages that would normally flow from a breach of the agreement.
First, some basics on terminology. What is an executory contract? In its simplest terms, an executory contract is one in which one or more of the contracting parties have yet to fully perform their obligations. Picture a contract to construct a new home. The construction is ongoing with certain obligations of the purchaser and builder during the course of construction over the contract term.
What is a liquidated damage provision in a contract? Think of an agreed upon damages provision that is negotiated between the contracting parties in order to establish damages in the event of a breach.
One would think that contracting parties agreeing in advance of a breach to the amount of damages would be universally accepted by the courts, but not always so. The initial litmus test is that a liquidated damage provision may not be a mere penalty for non-performance. Rather the damages provision must be reasonable in light of the anticipated or actual loss resulting from the breach. If the liquidated damages are unreasonably large, the clause will be found to be penalty which is against public policy and, therefore, unenforceable.
In Illinois and many other states, a liquidated damages provision will generally be found enforceable when three factors are met: (1) the parties intended to agree in advance to the settlement of damages that might arise from the breach; (2) the amount of liquidated damages was reasonable at the time of contracting, bearing some relation to the actual damages which might be sustained; and (3) actual damages would be uncertain in amount and difficult to prove. All three requirements must be met in order to successfully enforce a liquidated damages clause.
Consider the following illustration. Buyer enters into a contract with Seller for the purchase of a shopping center for the sum of $20,000,000. The proposed anchor tenant is in negotiations for space with Seller at the time that the purchase contract is being negotiated. Buyer and Seller agree to the following terms in the purchase contract; lease with anchor must be delivered by June 1, 2010; anchor tenant must obtain all permits for build out of the space by July 1, 2010; liquidated damage clause provides that $4,000,000 of the purchase price is to be held in escrow and to be returned to Buyer if the foregoing terms are not timely completed and released to Seller if the terms are timely met.
Anchor tenant lease is timely delivered but the permits are secured by anchor tenant 90 days late under the deadline established in the purchase contract. Buyer sues for the release of the $4,000,000 claiming a breach of contract; Seller counterclaims for a declaratory judgment that the liquidated damages clause is an penalty as it confers a windfall award to a non-breaching party and, therefore, unenforceable.
How do you think a court would rule following a trial? Consider the following facts: The parties agreed in advance to the settlement of the damages that might arise from the breach and presumably, given the agreed upon terms, the parties agreed that the amount was reasonable; and the damages appear to be uncertain and difficult to prove. The facts seem to support the release of the escrow money to the Buyer. Yet a recent decision in Illinois held otherwise. The court, in GK Development, Inc. v. Iowa Malls Financing Corporation, 2013 WL 6732121 (1st Dist. 2013) held that the liquidated damages clause was a penalty and against public policy and, therefore, unenforceable. The facts involved those similar to those used in my above illustration. The rationale for the court’s holding as to each of the three factors is summarized as follows:
- Did the parties intended to agree in advance to the settlement of damages that might arise from the breach? There was no evidence that Buyer and Seller considered what appropriate damages would be in the event of a minor delay in performing the terms of the contract. Stated alternately, no weight given to the fact that Buyer and Seller negotiated, at arms length, the amount of damages in advance of a breach– First factor for enforceability is not met.
- Was the amount of liquidated damages reasonable at the time of contracting or bear some relation to the actual damages which might be sustained? No, as the damages clause accounted for the complete failure of the anchor tenant to build out and occupy the space and did not account for a minor delay in securing a permit, thus the amount of damages did not bear any relation to delay in securing permits. – Second factor is not met.
- Would actual damages would be uncertain in amount and difficult to prove? The court did not address this factor as it was not necessary for its ruling. I suspect that if addressed, the court would have found the answer to be in the affirmative.
When negotiating a liquidated damages provision do not get too greedy; it is better to merely be a pig rather than a hog.