Liquidated Damages Clauses – Are they worth it?

Liquidated Damages Clauses – Are they worth it?

Ordinarily, in a dispute over the breach or performance of a contract where the aggrieved party is seeking a monetary award as compensation, the measure of those damages is the party’s “actual damages.”  Actual damages are just that—the measure of the aggrieved party’s actual loss, measured as the difference between the current circumstances and the circumstances that would have obtained had the contract not been breached.  The idea is to give the aggrieved party the “benefit of the bargain.”

In litigation, parties regularly dispute the amount of actual damages caused by a breach.  In some cases, this may be straightforward, but in complicated disputes the issue of determining the scope of damages is also likely to be complicated.  But under some circumstances, parties may choose to spell out the measure of monetary compensation owed for a breach of contract in the contract itself.  Such a provision, generally known as a “liquidated damages” clause, is intended to offer the parties some peace of mind about the amount of damages at issue in a suit for breach.

Do liquidated damages clauses actually provide that peace of mind?  Even though the parties may agree at the time of contracting as to their measure of damages, the validity a liquidated damages clause may still be challenged in a lawsuit, and such challenges can look an awful lot like proving actual damages—and can be just as contentious.

Washington courts apply a two-part test to determine whether to uphold a liquidated-damages clause.  First, the amount fixed by the clause “must be a reasonable forecast of just compensation for the harm that is caused by the breach.”  This means that the amount must have been, at the time of contracting, prospectively reasonable, but as determined through hindsight.  A liquidated-damages clause that awards damages not reasonably related to the measure of actual damages will not be enforced.[1]  Second, the harm “must be such that it is incapable or very difficult of ascertainment.”[2]

Taken together, these requirements seem contradictory at first glance.  Liquidated damages are properly awarded in situations where the true measure of damages is impossible or very difficult to ascertain, yet at the same time, the measure of liquidated damages must be reasonable in light of the actual damages caused by the breach.  Moreover, while the party seeking to enforce a liquidated damages provision does not need to prove actual damages under the reasonableness test, courts can and do consider proof of actual damages damages in evaluating the reasonableness of the amount awarded under a liquidated damages clause.[3]

In a hypothetical lawsuit over a breach of a contract that features a liquidated-damages clause, the aggrieved party will point to the liquidated-damages clause as the proper measure of damages.  The breaching party may then challenge the enforceability of the clause, because (a) the amount was not a reasonable estimate of actual damages at the time of contracting or (b) actual damages were not impractical or impossible to ascertain (or both).

Proof of actual damages quickly becomes relevant and discoverable in such a dispute.  Thus, litigation over the enforceability of a liquidated-damages provision has much of the same flavor—and involves much of the expense—as litigation over the measure of actual damages in the case where there is no liquidated damages clause.  Indeed, for the party seeking to uphold a liquidated damages clause, proving the prospective reasonability of the amount as of the time of contracting and the unreasonableness or inapplicability of any estimate by the breaching party as to the measure of actual damages could be more difficult and costly than proving actual damages.  To the extent the effort is worth it, presumably it is because the liquidated-damages amount exceeds actual damages, but the greater the disparity, the greater the likelihood that the provision will not be enforced.

In theory, the true purpose of a liquidated damages clause is to create an agreement as to the measure of damages in cases where the amount of actual damages genuinely cannot be ascertained—or is so difficult to ascertain that doing so would not be practical.  In such cases, the breaching party is likely to have a more difficult time establishing that the liquidated-damages clause is unenforceable.   So, when considering whether to include a liquidated-damages clause in a contract, it is important to ask whether it is possible to estimate how, and to what extent, damages might result from the other party’s breach.  If that is not hard—or if it would be just a matter of math, depending on the numbers—then a liquidated-damages clause may not be appropriate or, ultimately, enforceable and might only create extra cost and complexity in the event of litigation.

On the other hand, if the measure of damages is truly difficult or impossible to determine, a liquidated-damages clause may make sense, reduce the cost of litigation, and provide some predictability.

–Patrick D. Moore

[1] Nw. Collectors, Inc. v. Enders, 74 Wn.2d 585, 594 (1968).

[2] Mgmt., Inc. v. Schassberger, 39 Wn.2d 321, 327 (1951).

[3] Wallace Real Estate Inv., Inc. v. Groves, 124 Wn.2d 881, 893 (1994)