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Contract Damages: How Much Can You Agree To?

American law has a fairly robust respect for people’s freedom to contract, especially in cases where both sides are of equal bargaining power and sophistication. However, there are certain clauses that the law refuses to enforce either to protect society or to protect one of the parties to the contract. One area where this becomes especially important is in stipulating the damages for a breach of contract.

Oftentimes, people want to agree on what damages are available in the case of breach of contract before the breach occurs. This is especially true for contracts where the actual damages may vary widely or be difficult to estimate. Many parties prefer to settle in the middle, rather than risking a jury going to one extreme or the other. The law allows such agreements, known as liquidated damages.

However, the law does not allow the closely related idea of penalty clauses. Penalty clauses are extra damages that are designed to deter parties from breaking a contract. Because liquidated damages clauses are enforceable and penalty clauses are not, it is important to be clear about what the parties are agreeing to.

Liquidated Damages vs. Penalty Clauses

The core difference between a liquidated damages clause and a penalty clause is the goal behind it. A liquidated damages clause is designed to be a genuine pre-breach estimate of the damages the parties would suffer in the event of a breach of contract. It provides valuable certainty in the case of difficult to estimate damages. Conversely, penalty clauses are about deterrence or punishment. They are designed to provide extra incentives not to break the contract.

Florida law provides two factors that must be met in order for a clause to be considered a liquidated damages clause rather than a penalty clause. First, the damages must not be “readily ascertainable.” Second, the amount of damages in the clause must not be “grossly disproportionate” from a reasonable estimate of the damages that the breach would cause. Additionally, the clause must not be optional, meaning that the injured party may not choose to pursue either the liquidated damages or the real damages.

Courts often also look to the language used in the contract to help them make decisions about the clause. It is not conclusive, but a clause that discusses a reasonable estimate of the actual damages is more likely to be ruled a liquidated damages clause than one explicitly designed for deterrence.

Why Penalty Clauses Are Unenforceable

There are a variety of reasons that courts have given for refusing to enforce penalty clauses. One of the most common is general notions of fairness and equity. There is an idea that a person who breaches a contract should not have to do more than pay for the damage that they caused.

Beyond that, there are practical purposes. If the penalty clause of a contract would make an injured party more money than a successfully completed contract, then the putative victim has incentives to try to get the other party to breach the contract.

Penalty clauses are just one complexity that exists with regard to contract damages. If have recently been the victim of a breached contract, contact a Florida business litigation attorney at Pike & Lustig, LLP to discuss your case.

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