When drafting or negotiating any contract, businesses should give careful consideration to avenues of recovery in the event of a breach by the other party. At times, this determination is straight-forward, such as where a party fails to pay amounts owed. But the analysis can become complicated in situations where damages aren’t readily quantifiable, such as where a trade secret is misappropriated or a former employee solicits a company client. To simplify such issues, businesses include liquidated damages provisions in their agreements. The clauses provide for the payment of a stipulated amount of money if the agreement is breached. While commonplace, legal enforceability of such provisions is often overlooked by many business owners. Depending on the nature of the agreement, a liquidated damages clause may be worth considering, but is not always appropriate. Due to the many complexities involved, legal counsel is recommended to provide guidance on these issues.
Test for Enforceability
The test for determining whether a liquidated damages clause is enforceable varies somewhat between jurisdictions, but, commonly, courts evaluate the following two requirements:
- when the parties entered into the agreement, damages contemplated by the clause were uncertain, and
- the stipulated amount of damages is proportional to the actual damages.[1]
Are the Potential Damages Uncertain?
Breaches of most agreements typically involve an element of damages that is difficult to quantify. By way of example, where a party fails to pay an amount owed, the loss of income to the non-breaching party may cause it to lose an unrelated business opportunity.[2] The value of a trade secret or a loss caused by the departure of an employee is certainly difficult to quantify. Therefore, the “uncertainty” element generally does not pose an issue.
Are the Stipulated Damages Proportional to the Actual Harm?
If the liquidated damages are disproportional to the actual harm caused by the breach, a court will likely hold that the clause is an unenforceable penalty. Determining the appropriate damages amount can be a challenging balancing act.
On the one hand, a clause containing a lesser amount of damages is more likely enforceable, but may not adequately compensate the business for its losses. On the other, a larger figure may be deemed unenforceable. Further complicating the issue is that damages may vary depending on the breach. For example, a violation of a non-disclosure provision may cause substantially more harm than a breach of a non-solicitation clause. Certainly a misappropriation of a trade secret (e.g. Pepsi’s secret formula) could have an enormous financial impact, as opposed to soliciting an employee who can be replaced.
To remedy the competing factors, a contractual provision, such as a non-solicitation clause, can include its own liquidated damages provision.[3] The same can be included for all provisions that involve damages that are difficult to quantify, such as the disclosure of a trade secret. But such practice does not guarantee enforcement.[4] Rather, each provision must be properly tailored to the facts of the case to satisfy the elements set forth above.
Actual Damages Must Be Proven
But even where a liquidated damages clause is enforceable, and a breach of the agreement is apparent, recovery under the clause is not guaranteed. A party must prove it was actually damaged by the breach and cannot solely rely upon the liquidated damages provision for recovery.
In a recent decision by the U.S. District Court in Alexandria, P5 Solutions, Inc. v. Steinke[5], the plaintiff, P5, brought a breach of contract action against Steinke, a former employee, for failing to return 22,000 documents following his termination. Steinke’s employment agreement contained a clause that required him to deliver all information and data related to his employment upon termination, which he undisputedly violated. P5 sought recovery under the agreement’s liquidated damages provision, which provided for an award of $100,000. However, the court found that P5 hadn’t proven actual damages—possession of the information alone was insufficient. Therefore, it was not entitled to recovery under the provision.
The bottom line is that planning ahead can save headaches later on. Properly addressing the above issues requires careful consideration and professional legal advice. And, in the event of a breach, the liquidated damages clause should not be the sole consideration for recovering damages. Multiple avenues of recovery should always be considered.
If you have questions related to liquidated damages clauses, please contact a member of PilieroMazza’s Litigation & Dispute Resolution practice group.
Patrick Burns, the author of this blog, is a member of the Firm’s Litigation & Dispute Resolution and Labor & Employment Law practice groups.
[1] See Boots, Inc. v. Prempal Singh, 274 Va. 513, 518 (2007) (employing the uncertainty and proportionality elements); Greentree Fin. Grp., Inc. v. Execute Sports, Inc., 163 Cal. App. 4th 495, 501 (2008) (requiring that actual and stipulated damages bear a “reasonable relationship”); Quaker Oats Co. v. Reilly, 274 A.D.2d 565, 711 N.Y.S.2d 498, 500 (N.Y.App.Div.2000) (same). The party challenging the enforceability of the clause is required to prove both parts of the test. Baistar Mech., Inc. v. Billy Casper Golf, LLC, No. 141781, 2015 WL 10990120, at *5 (Va. Oct. 22, 2015).
[2] See WIS-Bay City, LLC v. Bay City Partners, LLC, No. 3:08 CV 1730, 2009 WL 1661649, at *8 (N.D. Ohio June 12, 2009) (recognizing that “missed opportunities to invest the money in alternative business ventures” could be proper grounds for a liquidated damages provision).
[3] See Baistar Mech., Inc. v. Billy Casper Golf, LLC, No. 141781, 2015 WL 10990120, at *1 (Va. Oct. 22, 2015) (recognizing the validity of multiple liquidated damages provisions in the same agreement).
[4] See Vegesina v. Allied Informatics, Inc., 257 Ga. App. 693, 695 (2002) (finding separate liquidated damages clauses unenforceable).
[5] 1:18-cv-01380 (E.D.V.A. Oct. 23, 2019).