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August 5, 2015
Whether a contractual clause seeking to pre-allocate damages in the event of a breach operates as an enforceable liquidated damages provision or an unenforceable penalty depends upon three factors, as stated by the Georgia Supreme Court:
See Se. Land Fund, Inc. v. Real Estate World, Inc., 237 Ga. 227, 230, 227 S.E.2d 340 (1976).
As an initial matter, the burden of proving that a clause is an unenforceable penalty rests upon the party who defaults on the agreement. See Caincare, Inc. v. Ellison, 272 Ga. App. 190, 192, 612 S.E.2d 47 (2005). Therefore, it is the breaching party’s responsibility to prove that one of the three above-listed factors is unsatisfied, in order to render the liquidated damages clause unenforceable. Also, “[t]he enforceability of a liquidated damages provision in a contract is a question of law for the court which necessarily requires the resolution of questions of fact.” Id.
The first factor (“the injury caused by the breach must be difficult or impossible of accurate estimation”) can simply be proven by testimony as to why it is difficult to accurately estimate damages. A survey of case law shows that parties rarely are able to show that injury caused by a breach was easy to estimate (e.g., that it was not difficult or impossible to accurately estimate). See Mariner Health Care Mgmt. Co. v. Sovereign Healthcare, LLC, 306 Ga. App. 873, 875, 703 S.E.2d 687 (2010) (damages found difficult to estimate where “when the parties entered into the contract . . . anticipated expenses for the new business venture could not have been easily calculated,” regardless of whether damages could be easily calculated after the fact); Fuqua Const. Co. v. Pillar Dev., Inc., 293 Ga. App. 462, 464, 667 S.E.2d 633 (2008) (damages found difficult to estimate where parties were “experienced” in their respective fields and stated in the contract that damages were difficult to estimate); Caincare, 272 Ga. App. at 192 (damages found difficult to estimate where parties did not argue that it would be easy to estimate damages); Joyce’s Submarine Sandwiches, Inc. v. California Pub. Employees’ Ret. Sys., 195 Ga. App. 748, 750, 395 S.E.2d 257 (1990) (presence of formula in contract for calculating damages in the event of breach does not by itself make damages easy to calculate). One of, if not the only, case in which the first factor was found unsatisfied dealt with an instance where damages were not difficult to estimate because they could “be calculated based on discrete values.” See Allied Informatics, Inc. v. Yeruva, 251 Ga. App. 404, 405, 554 S.E.2d 550 (2001). The simplest method by which to satisfy this element thus appears to be including in the clause an acknowledgement by the parties that damages are difficult to estimate and perhaps providing an explanation for such difficulty.
The second factor (“the parties must intend to provide for damages rather than for a penalty”) can also be shown by proof that a clause was not intended by the parties as a penalty. Given that the key to this factor is the intent of the parties, statements memorializing that intent have been given significant weight by Georgia courts, particularly since the language of the contract is the first indicator looked to by courts in analyzing this factor. See Caincare, 272 Ga. App. at 192 (calling the sum owed in case of a breach “liquidated damages” is “indicative of the parties’ intent for the damages to be liquidated”); Fuqua Const. Co., 293 Ga. App. at 464 (sum owed in case of a breach constituted damages rather than a penalty where parties agreed in contract that sum was “reasonable liquidation thereof and is intended not as a penalty”); Nat’l Emergency Servs., Inc. v. Wetherby, 217 Ga. App. 42, 44, 456 S.E.2d 639 (1995) (fact that contract called damages in the event of a breach “liquidated damages” established the parties’ intent since the court “must first look to the language of the contract to determine whether the parties intended the provision in question to be a penalty or a legally cognizable liquidated damages clause”). Thus, even though the label the parties place upon the payment provision is not determinative, courts nevertheless look to that label when attempting to divine the parties’ intent.
Finally, the third factor (“the sum stipulated must be a reasonable pre-estimate of the probable loss”) is typically the most heavily contested. However, this factor is satisfied so long as a party offers evidence satisfying the “touchstone” requirement that they “employed a reasonable method under the circumstances to arrive at a sum that reasonably approximates the probable loss.” See Caincare, 272 Ga. App. at 193 (emphasis added); see also Nat’l Emergency Servs., 217 Ga. App. at 44 (must present evidence of a connection between the pre-estimated sum(s) and a competent estimation of a probable loss, rather than mere speculation as to anticipated damages). Courts have held as a matter of law that pre-estimated damages representing only a small percentage of the contracted price are “reasonable and enforceable as a matter of law.” See Liberty Life Ins. Co. v. Thomas B. Hartley Const. Co., 258 Ga. 808, 809, 375 S.E.2d 222 (1989) (liquidated damages of 10% was reasonable); Fuqua Const. Co., 293 Ga. App. at 465 (liquidated damages of 2.06% was reasonable) (citing Oran v. Canada Life Assurance Co., 194 Ga. App. 518, 521, 390 S.E.2d 879 (1990) (liquidated damages of 2% was reasonable); and Swan Kang, Inc. v. Kang, 243 Ga. App. 684, 687, 534 S.E.2d 145 (2000) (liquidated damages of approximately 2% was reasonable)).
However, a liquidated sum that will clearly place a non-breaching party in a far better position than it would be but for a breach is unreasonable. See Caincare, 272 Ga. App. at 193 (citing Carter v. Tokai Financial Svcs., 231 Ga. App. 755, 758-59, 500 S.E.2d 638 (1998); and Peterson v. P.C. Towers, L.P., 206 Ga. App. 591, 593-94, 426 S.E.2d 243 (1992)). Furthermore, where it is obvious that parties made “no effort to estimate the probable loss,” a liquidated damages clause is unreasonable. See Caincare, 272 Ga. App. at 193 (citing Physician Specialists in Anesthesia v. MacNeill, 246 Ga. App. 398, 539 S.E.2d 216 (2000) (rather than attempting to estimate the probable loss, an employee and his employer merely referenced the employee’s deferred compensation package to determine the amount of liquidated damages)).
Courts favor finding a “penalty” when there is doubt as to the enforceability of a clause and accordingly limit recovery to damages actually shown. See Se. Land Fund, 237 Ga. at 230; Caincare, 272 Ga. App. at 195. However, the more that a clause functions like “compensation” rather than a “penalty intended to deter,” the more likely a court is to find the clause reasonable and enforceable. See id. at 193-94 (clause found to be a penalty where it entitled non-breaching party to $10,000 on day of breach and $100 every day thereafter, non-breaching party admitted clause was a “deterrent” and “worst case scenario,” and formula provided did “not prove parties took any steps to estimate the loss prior to the contract being signed”). Therefore, erring on the side of caution by including the obvious in a liquidated damages clause is more likely to render the clause enforceable rather than a penalty – an express intimation of two of the factors has been held enough to satisfy those elements, and thus should be included in every liquidated damages provision. Moreover, a clause is not unenforceable merely because, in retrospect, it turns out to be an inaccurate pre-estimation of damages – see Se. Land Fund, 237 Ga. at 230 (“the breaching party cannot complain that the actual damages are less than those specified as liquidated damages”) – the requirement is merely that prior to execution of the contract, a party performs its due diligence and pre-estimates damages in a reasonable manner, utilizing all of the information before it at that time, in order to accurately determine the value of its damages resulting from a breach, rather than attempting to deter the other party from breaching.
Any attorney drafting a liquidated damages provision should include a statement that tracks the case law by reciting that (1) damages arising from a breach are difficult to accurately estimate, (2) the parties intend for the provision to function as “liquidated damages” and/or as “compensation” rather than as a penalty to deter, and (3) despite the difficulty in estimation, the liquidated damages constitute a reasonable pre-estimate – while courts may not necessarily give an “‘A’ for effort,” providing a detailed explanation in the clause as to how an estimate was arrived at may persuade a court in a close case that the estimate is reasonable, particularly since a breaching party carries the burden of showing otherwise.