To A Hammer Everything Looks Like A Nail

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Knowing what you don’t know is a good thing. A practical application of that statement comes when you are trying to figure out how a particular jurisdiction will treat a particular agreement such as a lease. There are some legal principles that suffuse state law throughout the United States. The law of damages is NOT one of those principles. Yes, the generality of “damages” is pretty much the same all over, but the details are not. Here’s an example from a just-decided Colorado case from its Supreme Court.

The question that court considered was whether a seller could really make the choice of remedies provided-for in the following contract clause:

If Purchaser defaults in the performance of any obligation under this Agreement . . . Seller shall have the right to terminate this Agreement and shall be entitled to retain all or a portion of the Earnest Money and Construction Deposit . . . as liquidated damages (“Seller’s Liquidated Damages”). Alternatively and in lieu of Seller’s Liquidated Damages, Seller may elect to terminate this Agreement and recover its actual damages resulting from Purchaser’s default calculated in accordance with Colorado law, in which case Seller may seek an award of such actual damages and may retain an amount equal to the Earnest Money and Construction Deposit and apply such funds toward satisfaction of any such award. If Seller elects to seek actual damages, Seller must provide Purchaser with written notice of such election within 30 days after the end of Purchaser’s cure period, and if Seller fails to provide such notice, then Seller will only be entitled to Seller’s Liquidated Damages.

In essence, is it valid to provide: “Alternatively, Seller may elect”? For those who have something cooking in the oven, here’s its conclusion: “Yes.” In saying so, the Colorado court conceded that the law may be different in other jurisdictions such as Florida and Illinois. We won’t be saying much about those states where the law is not the same as it now appears to be in Colorado other than to reproduce what Richard A. Lord in Williston on Contracts (a law treatise) “has summarized (as) the philosophy of” those other states:

Courts examining such provisions have held that the option has the effect of rendering the provision an unenforceable penalty, on the basis that the option negates the possibility that the parties intended, in agreeing to the provision, to establish a specific sum payable in respect of a breach, and instead intended the provision to be operative only where the deposit exceeded the actual damages incurred, establishing the implication that the parties intended to punish the defaulting party.

Now, if readers remember our caveat and warning about thinking that we know what we don’t know, we’ll plow on about a “choice of damages” provision (applying a Colorado twist).

First, to get everyone on the same page when reading “liquidated damages,” we offer this breezy definition: a “liquidated damage” is a fixed dollar amount, set forth in an agreement, to be paid by a breaching party on account of its breach.  Second, when courts refuse to enforce an agreement’s “liquidated damages” provision, they most often call them an “unenforceable penalty.” Courts do not like private “penalties.” Perhaps that’s because courts want the exclusive right to impose penalties, but’s that’s a thought for another day (and not for Ruminations).

The Colorado Supreme Court has provided a pretty good, short, explanation of what makes for an enforceable “liquidated damages” provision:

A liquidated damages provision is valid and enforceable if three elements are met: (1) “the parties intended to liquidate damages”; (2) “the amount of liquidated damages, when viewed as of the time the contract was made, was a reasonable estimate of the presumed actual damages that the breach would cause”; and (3) “when viewed again as of the date of the contract, it was difficult to ascertain the amount of actual damages that would result from a breach.” If any one of the elements is not met, the provision is an invalid penalty. A penalty differs from a liquidated damages clause because “a penalty is designed to punish for a breach of contract[,] whereas liquidated damages are intended as fair compensation for the breach.”

The story told by the court is a simple one. A number of contract-buyers for “to be built” condominium units, after posting 15% contract deposits, failed to close on those purchases because they were unable to obtain financing. The builder/seller elected to retain the “Seller’s Liquidated Damages” (in the amount of the deposits) pursuant to the agreement’s provision we reproduced above.

The contract-buyers argued “that a liquidated damages clause in such a contract is invalid as a matter of law because an option to select between remedies necessarily means that the parties did not intend to liquidate damages and thus the liquidated damages clause operates as an invalid penalty.”

[Some readers may be curious, but (if we are right about why they would be curious), we won’t be very helpful. We don’t know if the “actual” damages incurred by the builder were more or less than the 15% deposits. Perhaps just to get this “legal” issue before the appellate courts, the contract-buyers stipulated that 15% was a reasonable estimate of what the damages might have been if they defaulted under the sales agreements.]

To recap, both the buyers and the seller agreed that elements (2) and (3) [reasonable estimate; damages difficult to ascertain] of the test for an enforceable liquidated damages provision were satisfied. That left element (1) in dispute: “Did the parties actually intend to ‘liquidate’ the damages”?

Strict contractarians will be pleased by the Colorado court’s approach. Its bottom line was as follows:

Applying these principles, we conclude that the parties here were free to bargain for liquidated damages as a sole and exclusive remedy, but they did not, and instead bargained for the risk allocation memorialized in the Damages Provision currently in the Agreements. Striking the option to liquidate damages in the Damages Provision, like [the contract-buyers] encourage, would be antithetical to the principles of freedom of contract and would require us to restructure the contract, which we are reluctant to do. …  (“The court’s duty is to interpret and enforce contracts as written, not to rewrite or restructure them.”)  …  The freedom to contract for the alternative damages remedies of liquidated damages and actual damages does not negate the parties’ intent to liquidate damages. All that this court requires is that “the parties intended to liquidate damages.” …  An intent to liquidate damages should not be conflated with an intent to liquidate damages as the sole and exclusive remedy. The parties must only mutually intend to make liquidated damages one of the available remedies that the non-breaching party could pursue. So long as the parties mutually intend the stipulated sum to be the agreed-upon measure of damages if the non-breaching party elects liquidated damages, the mutual intent element of [prior case law] is satisfied. Therefore, the mere presence of an option to seek either liquidated damages or actual damages does not render the liquidated damages clause invalid as a matter of law.

Though it may be hard to discern, it isn’t and wasn’t our intention to “discuss” liquidated damages today. Our primary purpose was to WARN readers that the law is NOT the same in every state. To write agreements as if the law is the same as where you are sitting may not bring about the certainty of result your agreement was intended to bring about. Today’s posting “proves” that by using a small example, one of many, many possible ones. Forewarned is forearmed.

Ruminations will probably write more about “liquidated damages” in a future post. And, in keeping with our general style, we will espouse our philosophy when doing so. We’ve written extensively about “damages” in the past. For those who have the time and inclination to do so, here are three such (sequential) posts for your reading pleasure: HERE, HERE, and HERE.

[The Colorado Supreme Court’s decision can be read by clicking: HERE.]


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