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. 

The Implied Duty of Good Faith and Fair Dealing: What Does it Mean for Virginia’s Businesses?

The duty of good faith and fair dealing has its roots in the Uniform Commercial Code (“UCC”), which applies to sales and other commercial transactions, and is now recognized at common law in some form in most jurisdictions. Numerous Virginia state and federal courts have held that the implied duty governs all contracts at common law. However, as the common law continues to evolve, it appears that Virginia courts have described and applied the implied duty in a seemingly contradictory fashion. As a result, what protection the implied duty offers in a contract remains unclear. Nevertheless, the implied duty continues to impact business litigation in Virginia and has altered the outcome of several cases. See Sun Trust Mortg., Inc. v. United Guar. Residential Ins. Co. of North Carolina, 806 F. Supp. 2d 872 (E.D. Va. 2011); Wachovia Bank NA v. Ranson Tyler Chevrolet, LLC, 73 Va. Cir. 143 (Roanoke 2007).

Some Virginia courts have held that breach of the implied duty is an independent cause of action, while others have held that it is merely a factor to be considered as to whether a breach of an express contract term should be further considered a material breach. Historic Green Springs, Inc. v. Brandy Farm, Ltd., 32 Va. Cir. 98 (Louisa County 1993) and Virginia Vermiculite, Ltd. v. W.R. Grace & Co. Connecticut, 156 F.3d 535 (4th Cir. 1998); but see RW Power Partners, L.P. v. Virginia Elec. & Power Co., 899 F. Supp. 1490 (E.D. Va. 1995). Moreover, some courts have held that a party may not exercise contractual discretion in bad faith, even when such discretion is vested solely in that party. Historic Green Springs Inc., 32 Va. Cir. 98; Virginia Vermiculite Ltd., 156 F.3d 535.

Often the express contract either does not address the particular dispute at hand, or applying the contract’s express language seems to give rise to an unfair result, which, the affected party will argue, was not anticipated when the contract was made and that the party seeking to take advantage of the omission or unanticipated application of the contract terms is not acting in good faith. Without such an implied duty, parties may defeat the purpose of a contract without breaching the express terms and suffer no consequences. However, the Virginia Supreme Court has cautioned that the implied duty cannot be the vehicle for rewriting an unambiguous contract in order to create duties that do not otherwise exist. Ward’s Equipment v. New Holland North America, 254 Va. 379 (1997). That is, an implied duty of good faith must yield to the express terms of the contract if the two are inconsistent.  

Virginia courts will likely continue to clarify the role of the implied duty of good faith and fair dealing in contract disputes. In the meantime, businesses should continue to be on their best behavior, and litigants and lawyers can look to the implied duty to help protect the legitimate expectations of the parties to a contract and mitigate the often harsh results of classic contract interpretation.

The author, Sara Dajani is an associate attorney at DC region business law firm, Berenzweig Leonard.  Sara can be reached at sdajani@BerenzweigLaw.com.