If one were to peruse a number of contracts, he or she should not be surprised to find that a majority of the contracts would have what is called a “liquidated damages clause.” They usually look something like this:
If the Hotel over-books, then, within 14 days of the occurrence of over-booking, the Hotel shall pay the customer as liquidated damages, and not as a penalty, an amount equal to 30% of the average Room Rate….
In the event of a delay of the completion of the project, the Contractor shall pay liquidated damages at a rate of a $100 per day of delay, subject to a maximum of 10 percent of the Initial Contract Price.
Drafting a valid liquidated damages clause is tricky because if it’s construed to be a penalty, then it is unenforceable. In 1959, the Minnesota Supreme Court stated, “this court has long regarded provisions for liquidated damages as prima facie valid on the assumption that the parties in naming a liquidated sum intended it to be a fair compensation for an injury caused by a breach of contract and not a penalty for nonperformance.” Gorco Constr. Co. v. Stein, 256 Minn. 476, 481(1959).
So how does one make sure that a liquidated damages clause is for compensation for damages and not a “penalty?” Since the Gorco case, Minnesota case law has provided some additional guidance:
- “The purpose of a penalty is to secure performance, while the purpose of stipulating damages is to fix the amount to be paid in lieu of performance.” Christianson v. Haugland, 163 Minn. 73, 75 203 N.W. 433, 434 1925);
- “In Minnesota, as elsewhere, a provision for liquidated damages is generally held to be a convenient substitute as a reasonable forecast of general damages.” Zirinsky v. Sheehan, 413 F.2d 481, 485 (8th Cir. 1969)(analyzing Minnesota law); and
- “The term ‘liquidated damages’ signifies the damages the amount of which the parties to a contract stipulate and agree, when the contract is entered into, shall be paid in case of breach….[a] stipulation of this kind if enforceable, at least in those cases where the damages which result from a breach of the contract are not fixed by law or are in their nature uncertain and where the amount stipulated does not manifestly exceed the injury which will be suffered.” Schutt Realty Co. v. Mullowney, 215 Minn. 340, 346, 10 N.W.2d 273, 276 (1943).
Takeaways from these earlier cases, which have been affirmed by more modern case law, are that any liquidated damages clauses are enforceable when 1) actual damages would be hard to ascertain; 2) the amount is actual fair compensation for an injury and not a penalty. See LeFavor v. Stuebner, 2004 WL 2283538 (Minn. Ct. App. Oct. 12, 2004)(finding a $50,000 penalty for default on a promissory note unreasonable penalty).
It should be further noted that it does not matter what the parties call any damages provision or what their intentions are. The only thing that matters is the legal effect of the provision.