Are Courts Finally Willing To Entertain Reasonable Liquidated Damages Clauses?

Land sales contract. Sumerian clay tablet, ca. 2600 BC., Taken by Marie-Lan Nguyen“It is true that, when people make contracts, they usually contemplate the performance rather than the breach.” – The Common Law, Oliver Wendell Holmes, Jr.

As the sophistication of contracting parties has grown, Holmes’ comment can be read today as an admonishment as much as it can be understood to express the mindset of contracting parties.  The body of case law on liquidated damages clauses in contracts that’s been created since Holmes first published The Common Law is proof that contemplation of the breach is now a necessary part of the contemplation of performance.

Today’s opinion, Ner Tamid Congregation of North Town v. Krivoruchko (IL N.D., Doc. No. 08 C 1261) is a must read for understanding that in the formation of a contract, the debate is far from dead between allowing sophisticated parties to commingle liquidated damages with the right to sue in a hybrid “election of remedies clause” and a simple Illinois public policy against those clauses.

The opinion from Judge Cole is a summation of the origins and state of the law regarding both the interpretation of contracts and liquidated damages clauses in agreements fit for a textbook.  Similar sets of facts are currently being litigated in courts across the nation given the economic downturn and the bursting real estate bubble. 

In this case, Ner Tamid sued Krivoruchko over the breach of a real estate contract.  The plaintiff congregation had entered into a real estate contract to sell land to the defendant.  $150,000 earnest money was placed in escrow by the defendant for the transaction – the land contract is here.  The real estate market went the way of the economy, or vice versa, and the defendant backed out of the deal.  The congregation sued, won on the issue of liability through a judgment of the court, and a trial was held on the amount of damages.

At trial the congregation argued that it was entitled to two separate measures of damages, 1) the difference in price between the property at the date of the contract’s formation and the value at the date of the breach (plaintiff claimed this was $850,000), and 2) expenses the congregation incurred while maintaining the property after the breach.  The defendant argued that there were no damages because the real estate values remained the same.  Both parties presented testimony from MAI appraisers.  The jury returned an award for the congregation of $98,219.07.  The defendant offered to turn over that amount to the congregation from the funds in escrow and take back the balance.

Then, perhaps not being satisfied with the award, the congregation refused the offer and filed a motion challenging the award and claiming that the contract allowed them to take the entire $150,000 in escrow as damages.  The opinion makes clear that this was the first time this novel interpretation of the contract agreement was put forth.  No such term is in the contract and the court pointed that out.

In rejecting the claims of the congregation, Judge Cole revived the debate surrounding the practicality of the public policy that, in contracts, a liquidated damages clause that is an election of remedies.  e.g. “We either get these liquidated damages, or we can sue for other damages, whichever we pick” – which is essentially what the congregation was arguing their contract said.

The debate is a long-standing one.  The rationale in Illinois that a contract’s liquidated damages provision cannot contain such an election comes from the rule of enforcing the provisions:

“Generally, a liquidated damages clause is valid and enforceable if: (1) the parties agreed in advance to the amount of damages that might arise from a breach; (2) the amount of liquidated damages was reasonable at the time the contract was entered, bearing some relation to the damages that might be incurred; (3) the amount of actual damages would be uncertain and difficult to prove; and (4) the damages must be for a specific amount for a specific breach - the damages may not be used as a threat to secure performance or as a penalty to punish nonperformance.”  Res. Tech. Corp. v. Cong. Dev. Co., 2003 U.S. Dist. LEXIS 15418.

The argument is that since the hybrid clause allows for one or the other, either liquidated damages or actual damages as proved in court, the parties did not agree to an amount (#1) and the amount is not specific (#4) because given the clause, the amount of damages could be either the liquidated amount or the actual amount.  Consequently, election of remedies can not be offered by a liquidated damages clause.

The opinion in Ner Tamid points out that the rational and ruling on such clauses in Illinois continues to date:

“[T]his scheme [an either/or election of liquidated or actual damages] distorts the very essence of liquidated damages, which in effect is to provide the parties with a pre-ordained settlement of a damage sum when actual damages would otherwise be difficult to determine” citing Catholic Charities of the Archdiocese of Chi. v. Thorpe, 318 Ill. App. 3d 304 (2000).

The opinion goes on, in short form, to question this rationale in a day when sophisticated parties could utilize such provisions in their agreements to obtain rational cost-benefit results through contracting and a court system would benefit from reduced case-loads.  After making the argument, the court, as we do, said alas and held that given the state of Illinois case law, even if such a provision were in the contract at issue, it would be void.  The final determination was that the jury award stand.

The black letter lesson remains that in contracting, parties need to pick either their liquidated damages or actual damages and can’t have both.  The aspiration remains that sophisticated parties could someday be allowed to offer each other a liquidated v. actual option as part of the bargain in their contracting.  That one party, feeling it stands to possibly lose more than the agreed liquidated damages in the event of a breach agrees to the contract on the condition that it be allowed to elect between a sum certain for liquidated damages or pursue some larger amount of actual damages is not so far fetched.  Neither is the scenario where the only way to achieve such a deal is to offer the option.  At worst, it affords a contracting party the comfort to know that when and if a breach occurs, it’s guaranteed some sum certain, and has the option to pursue more.

This is a valid business decision, yet the stated test for upholding liquidated damages clauses precludes the parties even attempting to achieve it.  At least we are starting to see the discussion and argument for changing the rule emerge.

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