The other day I was helping someone move. We arrived with the moving truck, and met the Landlord at the residence. The Landlord then proceeded to go over the terms of the lease along with the idiosyncrasies of the house. The soon-to-be tenant looked at the 5 page document and tried to listen as she went over some “key provisions”. She then showed him where to initial at the bottom of each page. It was late at night and we were both pretty tired from our prior activities and making the 3 + hour drive. She then moved on to the third page that had two items with blank spots ready to be filled in.
She stopped, and asked, “You don’t have any pets do you?”
“Nope”, said the tenant.
She then stated, “just because I want to (and proceeded to write $5,000 as the penalty for having a pet and for smoking in the house”.)
The $5k provision in case of smoking or pets was in essence a “liquidated damages” clause. Liquidated damages clauses are used in contracts to stipulate up front to damages because the actual calculation of damages would be difficult or an extreme burden to do.
At this point, I took notice. Was this even going to be enforceable? What if he decided to get a gold fish and she came through on an inspection? Could she walk out $5k richer? I didn’t say anything, and we unloaded. As I laid down to go to sleep at night I recalled the basic principles of contract law and the question kept going through my head, “Is it enforceable?”
Basic Principles in Contract Law
- Parties are free to negotiate for an agree to any lawful terms they want to.
- Remedies for contracts will usually go to restore the harmed party to a position as if the contract had been fully fulfilled, but not to enrich them.
- The court will only reform the contract if the contract is against public policy or is unconscionable (terms are egregious or patently unfair).
Parties should be able to negotiate for whatever they want. The remedy has to be tied to the harm someway or else contract law would be a sham. You would be asked to sign a 50 page agreement in 8 point font and somewhere hidden in the agreement would be some term that says if you breach you agree to pay $1,000,000. That is not how the system works. If it did work like that, then no one would sign contracts ever. This post is the result of me needing to be able to justify my gut feeling and verbalize the standard.
What is the law?
According to Section 356 of the 2d. Restatement of Contracts, liquidated damages for a breach may be spelled out in the agreement but only to the extent that they are reasonable in relation to the loss anticipated or actual loss caused by the breach. Liquidated damages are only appropriate when it is difficult to prove the amount of damages.
So what does that mean? This means that if we were designating the penalty for a certain type of breach i.e. having a pet in the house when the lease says you can’t the remedy is only enforceable if it meets both of these requirements:
- The anticipated damage or actual damage is reasonable in light of the circumstances.
- The damage is difficult to ascertain/measure.
A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy. As stated above, if it were enforceable, contracts would get in the way of people doing business rather than help them. In the case of pets in an apartment lease, the damage caused by pets would be readily ascertainable. If there were a dog and the dog through is poor hygiene habits ruined the carpet and the drywall, the damages would be the cost of the replacement of the carpet and the drywall. If there is a fish, the fish did absolutely no damage, then there would be no damages recoverable under the contract for the fish. The landlord could decide that the tenant was in breach and evict the tenant, but the landlord couldn’t use the Court to enforce the $5k penalty.
Rules of Thumb
When you are considering damage provisions in contracts, you can go by these guidelines:
- You can’t affix a term that spells out the damages, if the damages are not difficult to calculate. If the breach caused damage, then the non-breaching party’s claim will be equal to the damage caused. There is no reason to stipulate to damages beforehand.
- If the damages are difficult to calculate, then the parties can agree to a compensation amount, but that amount has to be reasonable (not just justifiable) in light of the circumstances.
When a liquidated damages clause is appropriate.
Liquidated damages clauses are used in all types of contracts. Sometimes they are appropriate and enforceable and sometimes they are used for scare tactics. Here is an example of when a liquidated damages clause would actually make sense: if employee Doyle quits and violates his non-compete and non-disclosure agreements with his previous employer and shares proprietary information that has given his previous employer a distinct advantage in the market place and because of these violations, Doyle’s new employer starts gaining market share these damages would be extremely difficult to calculate. You would have to calculate the lost profits of Company A, the increased profits of Company B, the value of repeat customers, the probability of Company B discovering the unique information on its own, and the lost opportunity because of the lost profits of Company A. In this type of case, it would be appropriate and enforceable to stipulate to a measure of damages beforehand.
Don’t be Intimidated by Unenforceable Large Numbers
The next time you see a liquidated damages clause that seems ridiculous, remember this article and see the clause for what it is; a scare tactic, and respond accordingly.