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March 1, 2010

Power Owners in Strong Position to Collect Liquidated Damages

By Judah Lifschitz, Esq. and James McMichael, Esq.

Traditional Model—Actual Damages Irrelevant to Enforceability

The traditional approach examines the reasonableness of the stipulated amount of liquidated damages at the time of contracting, without reference to actual damages incurred by the owner during the delay period. The retrospective analysis is immaterial in determining whether a liquidated damages clause is compensation or a penalty. For example, in the case of Carrothers Const. Co., L.L.C. v. City of South Hutchinson, 207 P.3d 231, 235 (Kan. 2009), the court held that “[t]he reasonableness of a liquidated damages clause in a contract deliberately entered into should be determined with regard to the conditions of the parties existing at the time the contract was executed, not from hindsight after the contract is breached.”

The Carrothers court reasoned that inclusion of a liquidated damages clause is “an advance settlement of the anticipated actual damages arising from a future breach [and] [s]uch provisions allow contracting parties to protect themselves against the difficulty, uncertainty, and expenses that necessarily follow judicial proceedings when trying to ascertain actual damages.” Thus, “it is well established that parties may stipulate at the time of contracting to a set damages amount for a breach of that contract, as long as the liquidated damages provision is not a penalty.”

Alternative Model—Actual Damages Determine Enforceability

The alternative approach looks at the reasonableness of the amount of liquidated damages specified, not only as of the date of contracting, but also by comparison to the actual damages incurred by the owner during the delay period. For example, in the case of Baker v. International Record Syndicate, Inc., 812 S.W.2d 53, 55 (Tex. App. 1991), the court held that “liquidated damages must not be disproportionate to actual damages . . . [i]f the liquidated damages are shown to be disproportionate to the actual damages, then the liquidated damages can be declared a penalty and recovery limited to actual damages proven . . . [t]his might be called the ‘actual harm’ test.”

Similarly, in the case of Healix Infusion Therapy, Inc. v. Bellos, 2003 WL 22411873, 2 (Tex. App. 2003), the court held that the party challenging the liquidated damages “still must show that, at the time the agreement was made, the amount of the liquidated damages was not a reasonable forecast . . . [t]o prove this defense, [the party] must prove actual damages, if any, to show that the actual loss was not an approximation of the stipulated sum.”