Flagging a penalty clause

Legal contradictions are seemingly plentiful in the world of law.
And among practicing attorneys – even longtime in-house counsel – the difference between a penalty clause and a liquidated damages provision in a contract is at the top of the list. The paradox is that while a true liquidated damages provision is enforceable, a penalty clause is not – even if parties knowingly and willfully agree to it.
To make this matter even murkier, it sometimes is difficult to determine if a contingent payment provision in a contract is a penalty provision or a legitimate liquidated damages proviso.
To gain a better sense of the nuances and the practical nature of the differences between the two types of clauses, lawyers need to be aware of a number of considerations and issues.
As an initial matter, the law of contract damages is designed to be compensatory, not punitive. Therefore, while courts will enforce contractual provisions that truly call for “liquidated damages” to be paid, they will not uphold clauses that merely penalize a party for not fulfilling its contractual obligations.
Further, a true and enforceable liquidated damages provision requires two circumstances to exist. First, at the time the contract was executed, it must have been difficult to determine the precise amount of damages caused by a breach. Second, at the time the contract was executed, the amount of the monetary payment required if a breach occurs must have been a reasonable estimate of the actual damages contemplated.

Now that’s entertainment
In an effort to better understand the distinction between penalty clauses and liquidated damages, let’s consider a hypothetical example involving a claim a company filed against an entertainer for breaching the parties’ endorsement agreement (by using a competitor’s products).
In the case, the entertainer was to be paid $3 million over two years to endorse the company’s products, with the last installment payment of $500,000 due at the end of the term. With two months left on the contract (and the entertainer having been paid $2.5 million), the entertainer breached his obligations by endorsing a competitor’s product.
Under the contract, such a breach required the entertainer to repay to the company an amount equal to the lesser of any portion of the endorsement fee previously paid to the entertainer during the term or $2.5 million.
While the company assumed it had an open and shut case for $2.5 million in damages, it soon learned that not only was the case not going to be an automatic victory, but also learned that it may not be able to recover much, if any damages.
The reason – even assuming the entertainer materially breached the agreement – emanates from the concept that “[t]he central objective behind the system of contract remedies is compensatory, not punitive.” Restatement (Second) of Contracts at § 356 (Comment a). As such, the $2.5 million payment provision only would be enforceable if it was a bona fide liquidated damages clause, as opposed to a penalty payment.
Applying the two-part analysis described above, the first issue (ease of estimating precise damages at the time the contract was executed) is likely to be resolved in the company’s favor. In other words, it would seem difficult to put a precise dollar amount on the monetary harm the company would suffer as a result of the conduct at issue.
As for the second factor, however (the reasonableness of the payment provision), the company appears to have little chance of success. The entertainer faithfully endorsed the company’s product for the first 22 months of a 24-month contract. Thus, it would seem difficult, if not impossible, for anyone to believe forfeiting the entire amount of money due the entertainer for a single breach was a reasonable estimate of damages. The entertainer would have the burden of proving the monetary payment is unreasonable, although in this instance the unreasonableness appears manifest.
Finally, if a provision is deemed a penalty, the courts will not reform it in any way. Rather, it will be deemed void, and the party claiming breach will have to prove its actual damages, regardless of how difficult that might be, or recover nothing.

Drafting tips
Here are a few tips for a company’s own protection when considering any type of clause that calls for another to pay money in the event of a contractual failure. First, the obvious: Never use the word “penalty” in your contracts. Always refer to a payment provision as “liquidated damages.”
While a formalistic labeling will not salvage the enforceability of a penalty clause, no good can come from the use of the term penalty (unless, of course, you are the party who might be liable for such a payment).
Second, contracts should also provide an acknowledgment by all parties that damages if a breach were to occur would be very difficult to ascertain and that based on specific factors spelled out in the contract the parties agree that a certain amount is a reasonable estimate of damages given what the parties know as of the date of the contract at issue.
Such language is no guarantee the clause will be upheld, but will put your company in a much more advantageous position than it might otherwise be.
Shepard Davidson is co-chairman of Burns & Levinson’s business litigation department and can be reached at [email protected]. He concentrates his practice in the areas of complex business torts, contract claims, real estate disputes and disputes involving closely held corporations.