By Adam M. Tuckman of Watt Tieder Hoffar Fitzgerald LLP
Beginning more than one century ago, owners and contractors generally have adopted the convention of including liquidated damages in their contracts to fix potential liability for delay (and other losses) at the inception of the project. The proliferation of liquidated damages clauses in modern contracts can be attributed to economic and legal factors. From the owner’s standpoint, it may be exceedingly difficult to prove the actual cost impact of a delayed project. A properly calculated liquidated damages rate would save the owner the significant expense of quantifying its delay damages. On the contractor’s side, a reasonable amount of liquidated damages may be preferable to uncapped or unknown liability, allowing the contractor to price its bid accurately and efficiently allocate risk.
Coinciding with, or perhaps a leading cause of, the industry’s embrace of liquidated damages provisions was the shift in courts throughout the country from disfavoring such clauses to accepting them (within limits) as an appropriate exercise of contract rights. While some variation exists among the states, courts have generally recognized that liquidated damages clauses are a viable alternative to proof of actual loss so long as (i) actual losses are difficult to quantify, and (ii) the stipulated sum bears a reasonable relationship to the anticipated loss at the time of contracting. See, for example, Restatement (Second) of Contracts § 356. Conversely, a clause that penalizes the breaching party, rather than estimating probable loss, is likely to be found unenforceable.
Liquidated damages provisions are not just as a remedy for delayed project completion. For instance, when contracting parties resolve pending or anticipated disputes by requiring payment from one party over time, the other party may insist upon including a liquidated damages provision in the settlement agreement to incentivize performance of the payment obligation.
Consider the following hypothetical. Party A is determined to file a lawsuit against Party B for $100,000. To avoid the lawsuit, Party B agrees to settle the dispute by paying $60,000 in monthly installments of $5,000 over 12 months. To ensure that Party B pays the installment payments, Party A demands a settlement term providing that, in the event Party B fails to pay all of the monthly installments, then Party B will be liable for the full amount of the original claim—$100,0000—net of any payments already made, plus an additional lump sum of $20,000 covering interest, attorneys’ fees, and other losses.
At first blush, the above hypothetical seems like a reasonable “carrot and stick” approach by which Party A, in agreeing to compromise forty percent of its claim, is shielded against the risk of Party B’s non-compliance with the settlement terms. A trio of court cases decided in the last two years—applying New York, California, and Florida law—however, demonstrate that a party’s ability to impose disincentives for nonpayment through a settlement agreement will be limited in certain jurisdictions. Under the facts of these recent cases, each court held that a provision in a settlement agreement obligating the payor to remedy a breach by paying a substantial sum of liquidated damages in addition to, or in lieu of, the settlement amount, was an unenforceable penalty. The courts struck down the respective liquidated damages clauses at issue because the stipulated sum was disproportional, and bore no relationship, to the actual damages that likely would flow from a breach of the settlement agreement.
The first of these recent cases was a 2019 decision by the California Second District Court of Appeal in Red & White Distribution, LLC v. Osteroid Enterprises, LLC, 251 Cal. Rptr. 3d 400 (Cal. Ct. App. 2019). In Red & White, the parties resolved a claim of default under a loan agreement. Their settlement required Red & White Distribution (R&W) to pay $2.1 million in installments over one year, but if R&W defaulted, then Osteroid Enterprises (Osteroid) could enter a stipulated judgment that required R&W to pay an additional $700,000 more than the settlement amount, plus interest and attorneys’ fees. Recognizing that California law generally limits recovery for the breach of a payment provision to the balance due plus interest, the court reasoned that the $700,000 additional payment had “no reasonable relationship to the range of actual damages the parties could have anticipated from a breach of the agreement to settle the dispute for $2.1 million.” Consequently, the court found the stipulated judgment to be an unenforceable penalty.
In late 2020, the Court of Appeals of New York reached a similar decision in Trustees of Columbia University in City of N.Y. v. D’Agostino Supermarkets, Inc., 162 N.E.3d 727 (N.Y. 2020), where the court refused to enforce a damages provision in a “Surrender Agreement” between a defaulting tenant and the landlord. The tenant, D’Agostino Supermarkets (D’Agostino), could not fulfill its lease with approximately $1,000,000 remaining due to the landlord, Columbia University (Columbia). To avoid the time and expense of an eviction process, Columbia agreed to accept $261,000 of the remaining lease balance, paid over time, along with D’Agostino’s agreement to vacate the property. When D’Agostino did not make all of the payments owed under the Surrender Agreement, Columbia argued that D’Agostino’s failure to pay the settlement amount rendered D’Agostino liable for the full balance of the original lease that was terminated, plus interest, taxes, and other costs. Over a vociferous dissent that would have upheld the Surrender Agreement as a proper exercise of freedom of contract, the court concluded that requiring D’Agostino to pay breach of contract damages, that would be 7.5 times more than if it fully complied with the Surrender Agreement, was a penalty and could not be enforced. Of particular note, the court emphasized that the Surrender Agreement, not the original lease, is the relevant agreement to determine whether the liquidated damages provision is proportional to the anticipated loss from a breach.
Finally, in 2021, the U.S. Court of Appeals for the Eleventh Circuit held in Circuitronix, LLC v. Kinwong Elec. (Hong Kong) Co., 993 F.3d 1299 (11th Cir. 2021), that, under Florida law, a settlement agreement provision establishing a $2 million liability for each breach of a covenant was a penalty and unenforceable. The court determined that the $2 million sum far exceeded the actual damages that might have been anticipated for any individual breach, which was expected to be less than $10,000.
While conventional wisdom is that liquidated damages provisions are routinely enforced, these recent cases demonstrate that the freedom of sophisticated parties to craft their settlement agreements will not always win the day, particularly when courts view the agreement as imposing excessive damages as compared to the probable loss that may be experienced by the non-breaching party. Indeed, the court in Red & White Distribution stated that it was publishing its opinion for the purpose of reminding “practitioners whose clients settle a dispute involving payments over time how to incentivize prompt payment properly, and what may happen if done incorrectly.” The court signaled, but did not decide, that an incentive structure may pass muster when the parties stipulate that the full amount of the claim is owed, apply a discount to the claim for timely payments, and then require full payment of the claim if the agreement is breached. While this approach may seem to be a distinction without a difference in practical effect, the key takeaway from the cases discussed above is that the appearance of a settlement procured through inequitable means may be avoided by carefully drafting the payment provisions in a settlement agreement. As construction claims and disputes frequently conclude with a commercial settlement, the industry should be mindful of the thin line that exists between a properly drafted incentive for prompt payment and an unenforceable penalty that could void the resolution of a claim or dispute.
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Adam M. Tuckman is a Partner with Watt Tieder. His entire career has been devoted to counseling contractors, subcontractors, sureties, and owners in all facets of risk analysis, dispute prevention, and dispute resolution arising from construction projects. He can be reached at [email protected] or 703.749.1000.