Court Weighs In On Validity of Liquidated Damages Clauses

It is not uncommon for business contracts to contain a liquidated damages clause that provides a set amount to be paid in the event a party breaches the contract. However, a recent decision from the Fairfax County Circuit Court could significantly impact how companies structure liquidated damages provisions in their contracts. In Sagatov Builders LLC v. Christian Hunt, the Seller (Sagatov Builders) and Buyer (Christian Hunt) entered into a contract for the purchase of real property.  As part of the contract, the Buyer was obligated to deliver a deposit of $50,000. The Seller subsequently filed a lawsuit alleging that the Buyer breached the contract and sought to retain the deposit as liquidated damages based upon a damages provision in the contract. The damages provision provided that—in the event of the Buyer’s default—the Seller would have the option to either retain the deposit as liquidated damages or pursue actual damages against the Buyer. The Buyer sought to dismiss the lawsuit arguing that an optional liquidated damages clause is a penalty as a matter of law, and the Seller was required to prove actual damages.

In considering the enforceability of the option clause, the Fairfax Circuit Court noted that to be enforceable, the liquidated amount must (1) be a reasonable estimation of actual damages which by their nature are difficult to ascertain, effectively avoiding all future questions of damage, and (2) not function as a penalty.
The court determined that the damage provision clearly did not avoid all future questions of damage and therefore the arrangement “fails to achieve the fundamental purpose of a stipulated damage provision.”  The provision also functioned as a penalty since it was intended only to be operative where the deposit exceeded the actual damages incurred, “establishing the implication that the parties intended to punish the defaulting party.”

As a result of this holding, parties must now show caution in designing a liquidated damages provision.  Since liquidated damages are intended to reflect future harm that is inherently difficult to calculate, contracting parties are now in the awkward position of needing to accurately determine a stipulated amount beforehand, or relying on litigation to prove actual damages. If parties decide upon a liquidated damages provision, this case should serve as guidance to no longer include the option to pursue actual damages if damages end up amounting to far more than the amount stipulated in the contract. This case should also serve as a good reminder to business owners and executives to revisit your commonly used boilerplate language that may be found in your contracts to ensure they are compliant and up-to-date with existing case law.

Nick Johnson is an attorney with Washington, DC business law firm Berenzweig Leonard. He can be reached at njohnson@BerenzweigLaw.com.