When a party to a contract breaches, the fundamental goal of the law is to place the non-breaching party in the same position it would have been had there been no breach. This does not always mean the non-breaching party gets what he sought under the contract. More often, the non-breaching party is awarded money (damages) for adequate compensation.
Penalty or Damage Provisions?
In some instances, the parties to a contract might wish to insert a provision in the contract which specifies the damages the non-breaching party may be entitled to recover. These provisions are called liquidated damage provisions. However, liquidated damage provisions can be found to be unenforceable, when the breaching party seeks to avoid the provision on the ground that it is a penalty. Typically, a penalty is one which greatly exceeds amount of damages actually sustained by the non-breaching party. Court will examine whether the actual damages incurred were much less than the liquidated damages imposed, measured at the time of the breach.
A liquidated damage provision is not a penalty when it reasonably estimates the harm that would result from a breach. But a provision not designed to be a penalty can nevertheless operate as one. The universal rule that damages for breach of contract are limited to just compensation for the loss or damage actually sustained. Accordingly, courts carefully review liquidated damages provisions to ensure that they adhere to the principle of just compensation. A damages provision that violates the rule of just compensation, however, and functions as a penalty, is unenforceable. Liquidated damages must not be punitive, neither in design nor operation.
Courts will enforce liquidated damage provisions when:
- “the harm caused by the breach is incapable or difficult of estimation,” and;
- “the amount of liquidated damages called for is a reasonable forecast of just compensation.” In applying the first prong, courts examine the circumstances at the time the agreement is made. The party seeking liquidated damages bears the burden of showing that the provision, as drafted, accounts for these two considerations.
A properly designed liquidated damages provision, however, may still operate as a penalty due to unanticipated events arising during the life of a contract. Courts must also examine whether “the actual damages incurred were much less” than the liquidated damages imposed, measured at the time of the breach. When a contract’s damages estimate proves inaccurate, and a significant difference exists between actual and liquidated damages, a court must not enforce the provision. When an “unbridgeable discrepancy” exists between “liquidated damages provisions as written and the unfortunate reality in application,” the provisions are not enforceable.
Enforcing Liquidated Damage Provisions
To be enforceable the liquidated damage provision, at the time the agreement was made, must meet a two-part test:
- The harm that would result from a breach must be difficult to estimate, and;
- The liquidated damages provision must reasonably forecast just compensation. Parties to a contract containing a liquidated damage provision are expected to negotiate a reasonable, not perfect, forecast of just compensation in the event of breach. A forecast that is inordinate when compared with actual damages will not prevail to a challenge when there is proof of a large variance between the actual damages and those sought under the liquidated damage provision.
A recital in the contract proclaiming that a liquidated damage provision is not a penalty will not save a provision that operates as one. Careful thought must be applied in determining a reasonable forecast of damages that would be sustained in the event of a breach. If damages, at the time of contracting are capable of calculation or can be fairly estimated, the provision cannot meet the first prong of the test.
Please feel welcome to reach out to our Murray-Lobb Attorneys if you have any further concerns or questions regarding a contract breach or liquidated damage provisions.