Publications

Liquidated Damage's Provisions in California

Jeffrey N. Brown & Linda M. Donner
California Real Estate Journal
March 13, 2006

Real estate contracts often contain "liquidated damages" provisions because damages for breach of contract can be difficult and costly to ascertain, and because these provisions can provide the parties added incentive to perform.

In deciding whether to use a liquidated damages provision and in drafting one, care should be taken so that a court, potentially years later, does not find that the provision is a penalty and, therefore, unenforceable. This article reviews the controlling authority governing the drafting and enforcement of liquidated damages provisions in California.

Historically, liquidated damages provisions were disfavored because courts considered them penalty clauses and, frequently, refused to enforce them. In 1977, California changed the policy of presumptive invalidity of liquidated damages provisions with a policy of presumptive validity in commercial, non-consumer contracts. Currently, with certain exceptions, a provision in a contract liquidating damages for a breach is valid unless the party challenging the provision establishes that it was unreasonable under the circumstances that existed at the time the contract was made.

A liquidated damages provision is not invalid merely because it is intended to encourage a party to perform, so long as it represents a reasonable attempt to anticipate the losses to be suffered. In Weber Lipshie & Co. v. Christian, a liquidated damages provision in a partnership agreement provided that the damages to the partnership for the loss of fees from any clients taken by expelled partners would be measured by the firm’s time charges for those clients for the 12 months immediately preceding their loss. Despite the parties’ reference to the provision as a “penalty” and evidence indicating the provision was intended to make it difficult for a partner who left the firm to take the firm’s clients, the court enforced the provision because it demonstrated a reasonable estimate of the harm that might be anticipated from the loss of the firm’s clients.

However, if the sole purpose of a liquidated damages provision is to coerce compliance with the contract, and not to compensate the “innocent” party for damages resulting from the breach, the provision is a penalty and unenforceable. As an example, in Ridgley v. Topa Thrift and Loan Association, the provision at issue allowed a lender to waive prepayment charges equal to six months' interest if the borrower made no late payments and was not in default under the note. The Ridgley Court considered whether the provision should be viewed as a valid charge for a prepayment of the loan principal or as an unenforceable penalty for delinquency in a monthly interest payment. Generally, contractual charges for prepayment of loan principal are valid provisions rather than penalties or liquidated damages for breach.

However, in this case, the provision was not construed as a prepayment charge because the nature of the threatened charge was to coerce timely payment of interest and not to compensate the lender for interest payments lost through prepayment of principal. The Ridgley Court held that a charge of six months’ interest on the entire principal, imposed for any late payment or other default, could not be defended as a reasonable attempt to anticipate damages from default.

Similarly in Harbor Island Holdings, L.L.C. v. Kim, the court invalidated a liquidated damages provision in a commercial lease which the parties had designated a “deferred rent provision.” The “deferred rent provision” was a conditional waiver which provided for double rent in the event of breach; the landlord would waive the penalty and charge half that rent amount in the absence of a breach. The court held that this provision could not be defended as a reasonable attempt to anticipate damages, stating that a contrary conclusion would allow unreasonable late charges or other penalties to escape legal scrutiny through simple rephrasing as a conditional waiver.

What both of these examples demonstrate is that the courts will analyze pre-determined damage or penalty provisions based upon their impact on the parties, and not necessarily on their designations. In neither of the last two examples was the provision under attack called a "liquidated damages provision," but the courts nonetheless reviewed the contracts under the standards for that type of provision.

Determining Reasonableness

A liquidated damages clause will generally be considered unreasonable, and, therefore, unenforceable if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.

The amount set as liquidated damages must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained. If there is no such relationship, the provision will be considered an unenforceable penalty, leaving the wronged party with the requirement of proving the actual damages sustained.

In deciding whether a liquidated damages provision is reasonable, courts generally examine all the circumstances existing at the time of the making of the contract, including the following factors:

  • the relationship that the liquidated damages bears to the range of harm that reasonably could be anticipated at the time of the making of the contract;
  • the relative equality of the bargaining power of the parties;
  • whether the parties were represented by attorneys at the time the contract was made;
  • the anticipation of the parties that proof of actual damages would be costly or inconvenient;
  • the difficulty of proving causation and foreseeability, and
  • whether the liquidated damages provision is included in a form contract.

Valid Options

Sophisticated sellers often select the use of options instead of liquidated damages provisions to avoid any issues as to enforceability. Payment of the option price avoids any issue for the seller of whether retention of a deposit is enforceable as liquidated damages.

However, use of labels is not enough to convince a court that a provision is an “option” versus a “liquidated damages” provision. Instead, courts examine the nature and terms of the agreement and the obligation of the parties. One test used by the courts is whether there is mutuality of obligation; if only one party is obligated to perform (the optioner-offeror), it is likely an option. The chief advantage of a true option is that it allows the optionee to inspect the property without meeting contingency requirements. Because the optionee has complete discretion to decide whether to exercise an option and proceed with the purchase, questions of good faith and satisfaction of conditions do not arise. As an example, in real estate purchase and sale agreements, a legitimate option often consists of an agreement to grant an irrevocable right to purchase in exchange for an option fee, and a separate purchase and sale agreement attached as an exhibit to the option.

In Allen v. Smith, the real estate purchase and sale agreement required the buyer to initially deposit ,000, remove all contingencies within 21 days of acceptance and thereafter increase the deposit by ,000 for a total deposit of 0,000, to be released to the seller as “non refundable purchase option monies.” The buyer did not complete the purchase and the seller retained the ,000 initial deposit as liquidated damages, as well as the ,000 additional deposit as an option fee. The court held that the provision at issue was not a valid option because the agreement contained no provision giving the buyer complete discretion to decide whether to proceed with the purchase. Rather, the contract required the buyer to remove certain contingencies within 21 days of acceptance.

Special Requirements

In addition to the reasonableness requirement, discussed above, a liquidated damages provision in real property purchase and sale agreements concerning the buyer’s default must be:

1) Separately signed or initialed by each party to the contract.

2) If the provision is included in a printed contract, it must be set out either in at least 10-point bold type or in contrasting red print in at least eight-point bold type.

“Printed” has been interpreted to mean preprinted, rather than typewritten. These special requirements are not applicable to provisions relating to remedies in the event of the seller’s default.

Specific Performance

Finally, especially in real estate transactions, specific performance is an important remedy for the parties. If the parties agree upon a liquidated damages provision, the remedy of specific performance is not necessarily waived. Parties should be careful as to whether they wish to have the liquidated damages be the “sole remedy” or just the substitute for damages. If the liquidated damages clause provides that the recovery of the specified sum as damages is the sole remedy in the event of default, the parties may have excluded the remedy of specific performance.

As the case law reflects, there is no bright line to determine the validity of a liquidated damages provision. In most commercial situations, such provisions are presumed valid unless the provision is shown to be unreasonable at the time the parties entered into the contract. Reasonability is an imprecise concept where the court considers and weighs many factors. Care must be given at the drafting stage to minimize the possibility of a court years later invalidating the intended provision.

About the authors: Jeffrey N. Brown is a litigation partner and Linda M. Donner is a litigation associate at Pircher, Nichols & Meeks in Los Angeles