Liquidated Damages Clauses

Lawyers often insert liquidated damages clauses into contracts, intending to specify the amount of damages that one party will receive if the other party breaches the agreement. These clauses can be efficient mechanisms for dispute resolution, eliminating the need to prove damages and, thereby, streamlining litigation (if not avoiding it altogether). However, California law places several restrictions on the enforceability of such provisions, with different requirements under different circumstances.

General Rules
Whether or not a liquidated damages clause is enforceable is a question of law. (Harbor Island Holdings v. Kim, 107 Cal. App. 4th 790, 794 (2003).) The question likely will turn on the facts of the case but also on several governing statutes that apply to specific types of transactions. But first a bit of background.

The California Civil Code mandates that a liquidated damages clause is valid unless a party establishes that it was "unreasonable under the circumstances existing at the time the contract was made." (Cal. Civ. Code § 1671(b).) However, this rule does not apply in cases in which another applicable statute prescribes a different standard. (See Cal. Civ. Code § 1671(a).)

A key exception is when the contract concerns the purchase or rental of personal property; a service used primarily for personal, family, or household purposes; or a residential lease. In those cases, a liquidated damages clause is void except when "from the nature of the case, it would be impracticable or extremely difficult to fix the actual damage." (See Cal. Civ. Code § 1671(c) and (d).)

The amount of liquidated damages stated in a contract also must represent a reasonable endeavor to estimate fair compensation for the loss sustained. If the stated amount is "designed to substantially exceed the damages suffered, and its primary purpose is to serve as a threat to compel compliance through the imposition of charges bearing little or no relationship to the amount of actual loss," then the purported liquidated damages clause will be an invalid attempt to impose a penalty. (Utility Consumers' Action Network, Inc. v. AT&T Broadband, 135 Cal. App. 4th 1023, 1029 (2006).)

In the Utility Consumers case, the court upheld the late fee in Internet cable service contracts (in which the amount was conceded to be reasonable), ruling that a company does not have to negotiate the late fee individually with each customer; the fee may be unilaterally set by one of the parties to a contract. (Utility Consumers, 135 Cal. App. 4th at 1025.)

In another case, the court of appeal struck down early-termination fees in consumer cell phone contracts, holding that the cellular telephone carrier (in this case, Sprint), failed the "reasonable endeavor" test because it did not undertake any effort to approximate the damages that would flow from a consumer's breach of contract. (Cellphone Termination Fee Cases, 193 Cal. App. 4th 298 (2011).)

Key Factors
Some cases are more instructive than others. In one instance, a federal district court upheld a liquidated damages clause that forced a buyer to forfeit a deposit for the purchase of a vintage car. The buyer had failed to pay the balance due, and the dealer sold the car to someone else for more money. The buyer sued for return of his deposit, but the court, after analyzing several factors, upheld the liquidated damages clause. The court quoted from the Law Revision Commission Comments to Civil Code section 1671 ("the amount of damages actually suffered has no bearing on the validity of the liquidated damages provision") and noted that the amount in question was a standard figure in vintage-car sales contracts - a key fact that supported a finding of reasonableness.

The court also cited other factors, such as "the relative equality of the bargaining power of the parties" and whether lawyers represented the parties when the contract was made. A crucial fact was that the buyer was sophisticated in the practices of buying and selling high-end vintage cars. In the overall context, the court observed that the amount of liquidated damages reasonably reflected the defendant's risk, as well as the damages that could have been anticipated at the time of contracting. (See Edwards v. Symbolic International, Inc. (2009 WL 1178662 (S.D. Cal.).)

However, in a different situation - involving real estate - the sophistication of the parties proved to be irrelevant. In Kuish v. Smith (181 Cal. App. 4th 1419 (2010)), a California appellate court held unenforceable a nonrefundable-deposit provision in a $14 million residential purchase contract. Both parties were deemed sophisticated, and the buyer backed out while the seller proceeded to sell the property for more money to a third party. But the result was far different from the vintage-car case.

In fact, the nonrefundable-deposit provision did not even appear to comply with Civil Code section 1675, which covers liquidated damages clauses in residential real estate purchase contracts. Interestingly, the Kuish court did not base its decision on section 1675. Rather, it noted that in a rising real estate market, where the property resells for more than the original purchase price, the seller has not sustained a loss. In that scenario, a nonrefundable deposit would constitute an unenforceable penalty. (181 Cal. App. 4th at 1427.)

To further demonstrate the point that context matters, another court held that a late charge of 10 percent in a promissory note was unenforceable when tacked onto a large balloon payment due upon the note's maturity. Although the regular installment payments (interest only) were $6,146.66 per month, the balloon was $776,146.66.

The 10 percent fee produced markedly different results, depending on the size of the missed payment. "A late charge provision covering administrative expenses that amounts to $614.67 for one late payment and $77,614.67 for another," said the court, "is not a reasonable attempt to estimate actual ... costs incurred, whether or not it is customary in the industry." (Poseidon Development, Inc. v. Woodland Lane Estates, LLC, 152 Cal. App. 4th 1106, 1116 (2007).)

Excess Damages
Some clauses provide for "per day" or "per month" damages. In such cases parties need to be careful, lest a court conclude that a clause that runs on forever is unreasonable. That is exactly what happened when the court struck down a liquidated damages provision in a lease that provided a late fee of $2,500 per day to the tenant if the landlord could not deliver completed premises by a specified deadline. Because the delay damages could continue in perpetuity, they imposed potentially unlimited damages, and therefore bore no rational relationship to the actual harm expected to flow from the breach. (See Dollar Tree Stores Inc. v. Toyama Partners LLC, 875 F. Supp. 2d 1058, 1073 (N.D. Cal. 2012).)

As many construction contracts contain "per day" provisions for delay damages, parties should carefully consider inserting a reasonable cap on delay damages in order to protect the concept from attack. (See also El Centro Mall, LLC v. Payless Shoesource, Inc., 174 Cal. App. 4th 58 (2009) (court of appeal upheld a 10 cents per day per-square-foot liquidated damages provision against a tenant for breaching its covenant to stay open for business).)

No Penalties
Closely related to the above line of reasoning is a code section that allows a party to be relieved from a "forfeiture" if full payment is made to the other party, provided there has been no "grossly negligent, willful, or fraudulent breach of duty." (See Cal. Civ. Code § 3275.) In essence, this rule means that a liquidated damages clause cannot amount to a penalty.

A case in point is Ridgley v. Topa Thrift (17 Cal. 4th 970, 979 (1998)). In that instance, the California Supreme Court held that a prepayment provision in a loan document constituted an unenforceable penalty because it applied only when the borrower was late with an interest payment; the liquidated damages were to be imposed in addition to a stipulated 10 percent late-payment fee. The court analyzed the interplay between Civil Code sections 3275 and 1671, noting that for a liquidated damages provision to be enforceable, it must bear a "reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach." The court then went further, commenting that "[t]he characteristic feature of a penalty is its lack of proportional relation to the damages which may actually flow from the failure to perform under a contract." (Ridgley, 17 Cal. 4th at 977.) In the Ridgley case the prepayment fee was approximately $113,000, which was equal to six months of interest. The court noted that the lender offered no plausible argument that the prepayment fee resulted from a reasonable endeavor to estimate fair compensation for any loss for late payment. (Ridgley, 17 Cal. 4th at 979.)

Conversely, a bankruptcy court upheld a $364,578 stipulated judgment against parties who failed to withdraw a bankruptcy claim by a deadline specified in a settlement agreement. (In re VEC Farms, LLC, 395 B.R. 674 (N.D. Cal. 2008).) The court declined to follow Sybron Corp. v. Clark Hosp. Supply Corp. (76 Cal. App. 3d 896 (1978)), which held that a settlement agreement calling for installment payments totaling $72,000 and allowing entry of a stipulated judgment for $100,000 upon any default was an unenforceable penalty.

Residential Transactions
Special rules govern liquidated damages clauses in contracts for the purchase of real estate containing up to four residential units, where the buyer intends to occupy one of the units as his or her residence. (Cal. Civ. Code § 1675(a).) To be valid, the liquidated damages provision must be separately signed or initialed and in at least 10-point bold type or 8-point bold and red type. (See Cal. Civ. Code § 1677.)

In general, subject to these prerequisites, as long as the liquidated damages provision does not exceed 3 percent of the purchase price the provision "is valid unless the buyer establishes that the amount is unreasonable as liquidated damages." (Cal. Civ. Code § 1675(c).) Conversely, if the amount paid exceeds 3 percent of the purchase price, the provision is invalid unless the party seeking to uphold it establishes that the amount is reasonable. (Cal. Civ. Code § 1675(d).)

Reasonableness is determined by taking into account the circumstances existing at the time the contract was made and the price and other terms and circumstances of any subsequent sale made within six months of the buyer's default. (Cal. Civ. Code § 1675(e).) Note, however, that for the initial sale of newly constructed condominium units within a project of ten or more residential units, a special rule applies that allows the seller to retain more than 3 percent under certain circumstances. (Cal. Civ. Code § 1675(f).)

These requirements have teeth. Indeed, one court held that when a minor delay in the deal triggered liquidated damages amounting to approximately 8.5 percent of the purchase price, the damages were unenforceable - even though the liquidated damages clause was contained in a court-approved settlement agreement that came into existence following specific performance litigation. (See Timney v. Lin, 106 Cal. App. 4th 1121, 1129 (2003).) Because the designated damages exceeded 3 percent of the purchase price, the liquidated damages clause was presumed invalid under section 1675(d). The fact that it was in a settlement agreement made no difference. Another case involved a buyer who failed to close escrow and sued to recover the deposit. The agreement limited liquidated damages to 3 percent of the purchase price and required any excess deposit to be returned to the buyer. A counteroffer provided the deposit would be released to the seller upon removal of contingencies as "nonrefundable option monies." The court concluded that the parties intended to enter into a purchase agreement, not an option, and ordered the portion of the deposit exceeding 3 percent of the purchase price to be returned to the buyer. (Allen v. Smith, 94 Cal. App. 4th 1270, 1279 (2002).)

The lesson here is straightforward: In a case involving a residential sale, the parties should limit the total liquidated damages to no more than 3 percent of the purchase price in order to benefit from the statutory presumption of validity.

Commercial Real Estate
The rules are different in the commercial context. Pursuant to the code, a liquidated damages clause in a nonresidential real estate purchase contract is presumed valid if the provision is separately signed or initialed by each party and, if contained in a printed contract, it is set out in at least 10-point bold type or in contrasting red print in at least 8-point bold type. Even so, if the party seeking to invalidate the clause establishes that the provision was unreasonable under circumstances existing at the time the contract was made, a court can still strike it down. (See Cal. Civ. Code § 1676 (which references sections 1677 and 1671).)

In Hong v. Somerset Associates (161 Cal. App. 3d 111 (1984)), the court upheld a liquidated damage clause in an apartment building-purchase contract. The designated damages were $25,000 in a transaction that called for a purchase price of $1,325,000 (slightly less than 2 percent of the purchase price).

One should note that the statutes dealing with liquidated damages in real estate purchase contracts do not affect a party's right to obtain specific performance. (See Cal. Civ. Code § 1680.)

Beware of Context
When drafting or analyzing a liquidated damages clause in a contract governed by California law, counsel should always remember that different rules apply, depending on the circumstances. However, keep in mind two fundamental guidelines in every case. First, a liquidated damages provision should be reasonable at the time it is drafted. Second, the greater the effort made to earnestly determine a fair measure of damages - as opposed to simply picking an arbitrary number - the better the chances the clause will pass judicial scrutiny.

Even though the rules that govern them are complex, liquidated damages clauses are useful. As one court observed: "liquidated damages do serve an important function. They remove the uncertainty factor from determining damages from a breach of contract and reduce litigation." (Utility Consumers, 135 Cal. App. 4th at 1038.) Compliance with statutory mandates will help assure that these goals remain within reach.

Steven H. Zidell is a partner at Wolf, Rifkin, Shapiro, Schulman & Rabkin in Los Angeles, where he specializes in real estate and business transactions.

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