Liquidated damages are damages the amount of which has been agreed upon in advance by the contracting parties. When a contract contains a liquidated-damages provision, the amount of damages in the event of a breach is either specified, or a precise method for determining the sum of damages is laid out. This is often done in situations where the parties agree that the harm likely to be caused by a breach would be difficult or impossible to measure with any precision, so they agree on a figure in advance and dispense with the time and effort that would otherwise be involved in proving compensatory damages at trial. Another benefit often cited is the ability to control exposure to risk that normally is inherent in business litigation.
Fairfax Circuit Court judge Charles J. Maxfield was recently presented with the interesting question of whether to enforce an optional liquidated damages clause, an issue not yet decided by the Virginia Supreme Court. Sagatov Builders LLC v. Hunt involved a sale of real estate. The seller alleged the buyer was supposed to pay a $50,000 deposit but didn’t. The parties’ contract contained the following provision:
If the Purchaser is in default, the Seller shall have all legal and equitable remedies, retaining the Deposit until such time as those damages are ascertained, or the Seller may elect to terminate the contract and declare the Deposit forfeited as liquidated damages and not as a penalty …. If the Seller does not elect to accept the Deposit as liquidated damages, the Deposit may not be the limit of the Purchaser’s liability in the event of a default.
The court began its analysis by noting that for a liquidated-damages clause to be enforceable, the amount must be a “reasonable estimation of actual damages which by their nature are difficult to ascertain” and cannot function as a penalty. Courts tend to enforce liquidated damages clauses where it appears the purpose of the clause is to reach an agreement on the amount of damages, whereas they tend not to enforce such clauses where the apparent purpose is to secure performance of the contract by punishing noncompliance.
Here, Judge Maxfield held that the optional nature of the provision demonstrated that the likely intent was to operate as a penalty rather than to accomplish any legitimate purpose that would satisfy the underlying rationale for enforcement of such provisions. He found the clause was unenforceable for two reasons: (1) an early Virginia Supreme Court case defined liquidated damages as stipulated damages “to avoid all future questions of damage,” a purpose an optional clause would obviously not accomplish, and (2) the option was a penalty in that it would only be exercised if the amount of the deposit exceeded actual damages.
The court sustained the defendant’s demurrer with leave to amend the complaint to seek actual damages only.