Penalty Clauses In Contracts- Beware
Many people assume that every clause in a contract is enforceable, so long as it was agreed to. But that is not true, and parties who make that assumption without further analysis do so at their peril.
Typical contract scenarios could include the following:
Scenario A: A and B enter into a contract that A will do X, but if A breaches, A must pay some daily penalty to B until performance occurs;
Scenario B: A and B enter into a purchase contract where A pays B 50% of the contract price, but if A fails to timely pay the rest according to the contract, the amount paid is forfeited to B and B gets to keep the property;
In the above scenarios, if A breaches, the parties are likely to fight over whether it is fair for B to receive a windfall at A’s expense, even though they agree that A breached the contract. Depending on the circumstances, the clause may or may not be enforceable. In Washington, as in the U.S. generally, contract law focuses on compensating non-breaching parties for their losses flowing from the breach, with the aim of putting them in as good a position as they expected to be in had the breach not occurred. Contract clauses which have the effect of placing the non-breaching party in a better position than if the contract were fully performed are presumptively unenforceable because they amount to penalties; the goal of enforcing contracts is not to penalize, but to prevent loss to the non-breaching party. Washington courts will strike down a clause deemed punitive. So does that mean that all similar clauses are unenforceable? Not necessarily.
The default rule in Washington is that a non-breaching party is only entitled to damages which they can prove. But a narrow exception to that rule exists where there is an enforceable “liquidated damages clause.” A liquidated damages clause is a provision which pre-determines the amount of damages in the event of a breach. But to be enforceable, the amount of damages in a liquidated damages clause must represent a “reasonable forecast” of what the parties expected would be the non-breaching party’s actual damages. Parties frequently agree to liquidated damages clauses because they can benefit both sides by avoiding costly and time-consuming disputes over actual damages.
A Hypothetical Illustration: Suppose a hotel rents out rooms, and you have booked 5 nights on certain dates, with the entire amount pre-paid. The day of check in, you call the hotel and cancel the entire reservation. The hotel has a policy that the entire pre-payment is forfeited if cancellation occurs fewer than 7 days before the date of check in. Would the hotel be allowed to keep the entire payment? It depends on whether the forfeiture clause is an unenforceable penalty or an enforceable liquidated damages clause, which in turn depends upon whether that forfeiture at the time of contracting represented a “reasonable forecast” of the hotel’s damages in the event of the guest’s late cancellation. The facts of each situation are unique. The hotel’s case would be stronger if it can show that, statistically, its guests book far in advance and it rarely has last-minute check ins. This is because such facts would tend to make it very unlikely that the hotel would recoup the lost revenue by filling the cancelled room at the last minute. But if the majority of the hotel’s bookings were last minute and it had a very low vacancy rate, the cancelling guest would have a greater chance of showing that the hotel was unlikely to suffer actual damages from the cancellation, and that the forfeiture clause represents an unenforceable penalty.
There are ways to mitigate the likelihood of a dispute over the enforceability of such a clause. First, parties should take the time to consider, at the time of contracting, whether the clause is a “reasonable forecast” of the non-breaching party’s anticipated actual damages. If it is not, the clause or pre-determined damage amount could be adjusted to come in line with such a reasonable forecast. Second, if there are specific risks, damages, or inconveniences which the non-breaching party would face in the event of a breach, it is a good idea to recite such facts in the contract to justify the clause as being an enforceable liquidated damages clause.
The lawyers at Beresford Booth have a wealth of experience with drafting contracts and litigating over breaches or alleged breaches. We can assist clients with crafting clauses with an eye toward making them fair and enforceable. We can also assist clients in the event a clause in a contract is disputed or potentially unenforceable. We look forward to serving your needs.
If you are interested in Penalty Clauses In Contracts, email us at info@beresfordlaw.com, or give us a call at 425-776-4100.