Liquidated Damage Provisions: Are They Always Enforceable?

By William Coats, director, member of the executive committee and the head of the construction/surety section of Houston-based Coats/Rose.

This month, we provide a brief overview of the analysis that the Texas courts apply when evaluating liquidated damage provisions and discuss steps that may be utilized to minimize the effectiveness of potential challenges in subsequent litigation.

Construction contracts often contain a liquidated damage provision that provides for payment a stipulated amount in the event that work is not completed within a specified period. Owners often impose these provisions to ensure the timely performance of the work by penalizing the contractor if the work is not completed on time. However, this type of rationale may result in the liquidated damage provision being held to be unenforceable if it is challenged.

The universal rule for measuring damages for a breach of contract claim is just compensation for the loss or damage actually sustained. As a result, a party should generally not be awarded more or less than their actual damages. Although competent parties generally have the right to make their own bargains, this right is not unlimited.

The same is true for liquidated damage provisions. Courts will enforce these provisions provided that they are not inconsistent with the general rule of just compensation. As a result, a liquidated damages provision will generally be upheld if it was created by the parties in an attempt to estimate, in advance, the damages that will be suffered in the event of a material breach.

If the provision was created to ensure timely performance by penalizing the other party if work is not completed on time, the provision will be held to be a penalty. In such a case, the provision is unenforceable and the non-breaching party will still be entitled to recover its actual damages.

In evaluating whether a provision is an enforceable liquidated damage provision, Texas courts have looked to the following factors:

• Whether the amount stipulated in the contract is a reasonable forecast of just compensation for the harm that is caused by the breach
• Whether the harm that is caused by the breach is one that is incapable or very difficult of accurately estimating
• Whether the amount of liquidated damages to be assessed is disproportionate to the amount of actual damages incurred
• Whether the liquidated damage provision applies equally to both material and minor breaches
• Whether the liquidated damage provision was not intended to provide fair compensation for the breach but to secure performance of the contract.

Owners have often attempted to address these factors by drafting the liquidated damage provision to specifically state that the provision is not intended to be a penalty. To the extent that the provision has been negotiated, this language may be of some assistance to the owner in attempting to prove the parties' intent. It should be emphasized, however, that such language is not binding on the court.

Courts analyze the liquidated damage provision to determine whether it was an actual attempt by the parties to estimate, in advance, the damages suffered as a result of a particular breach. As a result, the liquidated damage provision should be tailored to the particular contract. When the owner uses the same amount for liquidated damages in all of its contracts, courts will often find that the provision was intended as a penalty and, therefore, unenforceable. Similarly, if the same amount of liquidated damages will be triggered by either a material or minor breach, courts have held that the liquidated damage provision is unenforceable even if there has been a material breach.

A party who is seeking to craft a liquidated damage provision that would be upheld by the Texas courts should consider a pre-contract analysis as to what the potential damages could be if the work were not completed on time. The analysis should be documented in the file. Moreover, if the parties are able to discuss this analysis and negotiate the stipulated sum to be paid, it will lend more credence to the reasonableness of the estimate.

Provisions should be crafted so that they do not apply equally to both a minor and material breach. A liquidated damage provision that applies equally to "the failure to perform any obligation required by the contract" should be avoided.

As well, the use of the same stipulated sum for every contract should be avoided as it undermines the contention that the stipulated sum was intended as a reasonable estimate of the damages to be suffered for that particular contract.