Contracts and Liquidated Damages
Cal. Civil Code Sections 1671 and 3275 taken together with case law establish that, at least in the context of commercial transactions, liquidated damages provisions, though once disfavored, are now generally presumed valid and enforceable unless a party establishes that the amount of liquidated damages was “unreasonable under the circumstances existing at the time the contract was made.” Sounds reasonable, but what the courts are getting at is that the amount of liquidated damages must represent a reasonable endeavor to estimate fair compensation for the loss sustained when the contract is breached/terminated.
Although it’s permissible for the clause to be intended in part to encourage full performance, that cannot be its sole purpose. As such, the amount of liquidated damages must generally bear some reasonable relationship to the actual damages that the parties could have anticipated when they entered into the contract. If the clause does not meet these tests, it is an unenforceable “penalty.”
While it’s only required by statute in commercial and residential real estate sale contracts, it’s not a bad idea to have your customers initial the liquidated damages clause, because one of the factors the court looks at in determining whether to enforce them is whether or not the clause is in a form/boilerplate contract and does not specifically come to the customer’s attention. The court also looks at other factors, such as whether the parties both had lawyers, the relative bargaining power of the parties, and the foreseeability and difficulty of proving actual damages, but in commercial transactions, those latter factors may be of less importance in my view.
Just remember the court will enforce or not enforce based on its analysis of all the facts and circumstances of the case and the factors outlined above. Again, no guaranties can be offered, but there are instances where a well-drafted and thought-out liquidated damages clause that is reasonably related to actual damages can serve its purpose to encourage customers to stay and be enforced. Look to your lost profit and what administrative costs arising from the termination you could factor in. You don’t have to say how you arrived at the amount in the contract, you just have to be prepared to prove it’s reasonably related to actual damages that were predictable at contract inception if you ever wind up in court. In real estate contracts, liquidated damages provisions must be separately signed or initialed and set-out in 10 point bold or 8 point bold red type. In consumer real estate contracts, clauses should generally be limited to 3 percent of the purchase price.
CC 1671, CC 3275, Utilities Consumers' Action Network, Inc. v. AT&T Broadband, Cellphone Termination Fee Cases, Harbor Island Holdings v. Kim, Edwards v. Symbolic International, Inc., Ridgley v. Top Thrift, et al.