Fixing the Damages in Advance: Recent Case Law Involving Liquidated Damages Provisions
When negotiating a contract, parties may choose to establish the damages owed if a party breaches. These pre-determined amounts, known as “liquidated damages”, commonly appear in real estate contracts, where the actual damages suffered from a breach are difficult to quantify.
For example, a contract may authorize a seller of real property to retain a buyer’s down payment if the buyer breaches by failing to appear at a closing. Moreover, a lease may also establish the amount owed to a landlord by a tenant based on a tenant’s breach, including an acceleration of rent.
Liquidated damages provisions are enforceable if they are not unconscionable or against public policy. The enforceability of liquidated damages clauses is frequently litigated. This blog highlights a pair of court decisions from this summer which demonstrate the fact-specific nature of this analysis.
Liquidated Damages Provision Upheld in Commercial Sale Contract
In July, the Appellate Division Fourth Department upheld a liquidated damages provision in a real estate contract which limited damages to the amount paid in escrow. See Rome Gas, Inc. v. Fastrac Properties I, LLC, 196 AD3d 1159 (4th Dept. 2021).
There, the liquidated damages clause stated: “In the event the Agreement is not closed due to the fault of the Seller, the money paid in escrow shall be returned to the Purchaser. In such event neither party shall have any further claim against the other.” Id. at 1159.
Following a breach by the Seller, the Purchaser sued the Seller and claimed additional damages beyond those provided by the liquidated damages provision. The Purchaser argued that the liquidated damages provision was “unconscionable and therefore unenforceable.” Id. The Fourth Department upheld the lower court’s ruling that the liquidated damages provision was valid and therefore damages were limited to its terms. The Fourth Department considered that the contract was negotiated by sophisticated commercial entities and evaluated the context, purpose, and effect of the liquidated damages provision to determine it was not procedurally or substantively unconscionable. The Court explicitly rejected the Purchaser’s argument that the contract was “procedurally unconscionable” because the Purchaser “was not initially represented by counsel” during negotiations. Id. at 1160.
Rome Gas provides an example of a non-breaching party arguing that a liquidated damages clause was unconscionable because it was too limited and did not fully compensate it for its damages. The case discussed below presents a more common example of a breaching party asserting that liquidated damages are disproportionate to the loss sustained and constitute an unenforceable penalty.
Liquidated Damages Provision Accelerating Rent Enforceable Against Guarantor
In May, the New York County Supreme Court examined a liquidated damages clause in a commercial lease. See Malcolm Shabazz Dev. Corp. v. Wu, 71 Misc. 3d 1221(A) (Sup. Ct. N.Y. Cnty. 2021). The provision made the tenant liable for rent through the balance of the lease term if the landlord terminated the lease based on the tenant’s breach. After the tenant breached, the landlord terminated the lease and then sued the tenant’s guarantor for amounts due, including liquidated damages.
In defense, the guarantor argued that the liquidated damages were an unenforceable penalty because the landlord was using the premises for its own benefit and therefore “did not sustain any damages from the loss of its tenant.” Id. at *2. The court rejected this argument, finding there the guarantor did not establish the alleged use of the premises by the landlord “would necessarily render the liquidated damages provision so disproportionate to plaintiff’s actual injury as to be an unenforceable penalty.” Id. at *3.
Significantly, the guarantee signed by the guarantor expressly waived unenforceability defenses. The court found “given this waiver of unenforceability-based defenses, [the guarantor] would remain obligated to pay post-termination liquidated damages under the lease even if those damages could not be assessed against the tenant.” Id.
As shown by the above cases, both breaching and non-breaching parties may assert that liquidated damages provisions are unenforceable. While this blog discusses commercial real estate matters, liquidated damages clauses are utilized in other contexts as well, including construction contracts for failing to complete projects by required dates and in employment contracts for breaches of restrictive covenants. The ability to enforce such these provisions depends on the language of the agreement at issue and the specific facts of the case.
Rob Yawman is an Associate Attorney at Adams Leclair LLP. Rob’s practice focuses on business litigation and commercial landlord and tenant disputes.