When utilized in contracts and leases, a liquidated damages clause can serve as a tool to avoid unnecessary litigation. In situations where a party has breached the terms of a lease, the parties can include a liquidated damages clause in order to determine the amount to be paid upon default for damages resulting from the breach. Courts have typically upheld such clauses as long as the agreed upon amount is not deemed a penalty or punitive. Several factors are taken into consideration when determining whether a liquidated damages clause will bring the lessor party whole or act as a penalty to the lessee/lessor.
Generally speaking, the U.S. Supreme Court stated in Priebe & Sons, Inc. v. United States1 that liquidated damages provisions can be useful when fair and reasonable, and that they are a “particularly useful function when damages are uncertain in nature or amount or are unmeasurable.”2 The Tenth Circuit Court of Appeals ruled that the burden of demonstrating 1) the damages would be difficult to ascertain and 2) the liquidated damages provision isn’t punitive rests on the party seeking to enforce the clause.3 When ruling, the Courts will look to:
- The specific lease;
- The state law upon which it was drafted or agreed upon; and
- The facts and circumstances surrounding each case.
Note that if the Court finds that the liquidated damages provision constitutes a penalty, the provision will be deemed void even if the damage resulting from a breach would be difficult to ascertain.4
When lease terms are breached before or during a bankruptcy, liquidated damages may fall under the jurisdiction of the Bankruptcy Courts. The timing of a breach of terms is significant in bankruptcy matters. Was the lease breached by the bankruptcy debtor prior to filing for bankruptcy? If so, those damages would be calculated as part of the pre-petition debt and amount necessary to cure a default in order for the lease to be assumed. When parties in a bankruptcy are deciding whether or not to assume the lease, 11 U.S.C. § 365(b) (1) provides that should a lease be assumed, the amount due and owing under the lease must be cured or provide adequate assurance that the lease will be cured, as well as provide assurance of future performance. Should a requirement be made to pay the liquidated damages as part of the cure? Unless otherwise objected to, it should be part of the cure. The bankrupt debtor could be the party attempting to enforce the liquidated damages provision to reduce the cure amount. In either situation, is the party seeking to collect on the liquidated damage provision able to show that those damages are actual damages that have been incurred? The party seeking to meet the burden of proof will need to show that the calculated liquidated damages were meant to make the party whole in anticipation of the breach and not act as a penalty. Resolution of such an issue could be lengthy depending upon the provision and amount. It is possible that the lease can be assumed pending resolution of the cure amount and whether or not it includes the liquidated damages.
Ideally, liquidated damages should be used when actual damages are not able to be ascertained at the time of the execution of the contract or lease. In order to be enforceable, these damages should not be disproportionate to the contract or lease amount. How can a party ensure the provision is enforceable in order to minimize the risk of litigation should a breach occur? The parties should:
- Confirm that reasonable damages are not able to be ascertained at the time of the drafting of the contract or lease.
- Decide on a specific number that would make the non-breaching party whole (i.e. rents, insurance, anticipated attorney fees/costs) based on the type of breach.
Thoughtful consideration should be given to the calculation of potential breach damages. Providing a haphazard amount could result in litigation in state or bankruptcy court.
To help avoid unnecessary litigation, creditors and lessors should seek immediate legal assistance when navigating this legal process. Bernstein-Burkley, P.C. is experienced in such matters and can lend its legal expertise in dealing with liquidated damage provisions in both state and bankruptcy courts.
- Preibe & Sons, Inc. v. United States, 332 U.S. 407 (1947)
- Yale 41 Associates, et al v. Five Shopping Center Company 16 Fed. Appx. 921 (2001)
- Yale 41 Associates, et al v. Five Shopping Center Company 16 Fed. Appx. 921 (2001); Sun Ridge Investors, Ltd. v. Parker, 956 P.2d. 876, 877 (Okla. 1998)