Court Holds Liquidated Damages Clause to be an Unenforceable Penalty

• Posted on: Dec 24 2018

Commercial contracts often include a liquidated damages clause that provides for the payment of a predetermined amount of damages in the event of a breach by one of the parties. Such clauses are often found in contracts for the sale of real property, commercial leases, and construction contracts. Given the consequences of liquidated damages clauses, it is important to understand when and how such a clause will be enforced.

What are Liquidated Damages?

A liquidated damages clause specifies a predetermined amount of damages owed by a party in breach of a contract. The amount is determined by the parties at the time they execute the agreement and is intended to be their best estimate of the damages that would be incurred in the event of a breach of the agreement. Truck Rent-A-Ctr. v. Puritan Farms 2nd, 41 N.Y.2d 420, 424 (1977) (Liquidated damages are “an estimate, made by the parties at the time they enter into their agreement, of the extent of the injury that would be sustained as a result of breach of the agreement.”).

Are Liquidated Damages Clauses Enforceable?

If the predetermined amount of damages “is manifestly disproportionate to the actual” harm suffered, courts will not enforce the provision on the grounds that it is a penalty instead of an estimate of actual damages. J.R. Stevenson Corp. v. Westchester Cty., 113 A.D.2d 918, 920 (2d Dept. 1985) (“If the amount stipulated in the liquidated damage clause is manifestly disproportionate to the actual damage, then its purpose is not to ‘provide fair compensation but to secure performance by the compulsion of the very disproportion,’” and the clause is unenforceable) (quoting Truck Rent-A-Ctr., 41 N.Y.2d at 424). Whether a contractual provision is “an enforceable liquidation of damages or an unenforceable penalty is a question of law, giving due consideration to the nature of the contract and the circumstances.” 172 Van Duzer Realty Corp. v. Globe Alumni Student Assistance Ass’n, Inc., 24 N.Y.3d 528, 536 (2014). The burden is on the party seeking to avoid liquidated damages to show that the stated liquidated damages are, in fact, a penalty. P.J. Carlin Constr. Co. v. City of New York, 59 A.D.2d 847 (1st Dept. 1977); Wechsler v. Hunt Health Sys., 330 F. Supp. 2d 383, 413 (S.D.N.Y. 2004).

A liquidated damages clause is unenforceable in two circumstances: (1) if the damages flowing from a breach of the contract were easily ascertainable at the time of execution; or (2) if the damages fixed were “conspicuously disproportionate” to the probable losses. Truck Rent-A-Center, 41 N.Y.2d at 425 (explaining that the “actual loss [must be] incapable or difficult of precise estimation” and the amount liquidated must bear “a reasonable proportion to the probable loss.”); JMD Holding Corp. v. Cong. Fin. Corp., 4 N.Y.3d 373, 380 (2005). New York courts often strike liquidated damage clauses when they fail to meet the foregoing. See, e.g., Sina Drug Corp. v. Mohyuddin, 122 A.D.3d 444, 445 (1st Dept. 2014) (holding that liquidated damages clause providing that defendants would pay $1 million if they refused to indemnify plaintiffs was an unenforceable penalty); Motichka v. Cody, 5 A.D.3d 185, 187 (1st Dept. 2004) (holding that a provision requiring payment of $1,000 per day if defendant failed to pay within 60 days was an unenforceable penalty, since damages were easily ascertainable by calculating interest accrued from time of breach); LeRoy v. Sayers, 217 A.D.2d 63, 69-70 (1st Dept. 1995) (invalidating lease term in which tenant forfeited $63,500 in deposits regardless of whether tenant terminated agreement with several months’ notice).

“Where the court has sustained a liquidated damages clause the measure of damages for a breach will be the sum in the clause, no more, no less. If the clause is rejected as being a penalty, the recovery is limited to actual damages proven.” Brecher v. Laikin, 430 F. Supp. 103, 106 (S.D.N.Y. 1977) (citations omitted).

Perseus Telecom, LTD. v. Indy Research Labs, LLC

On November 30, 2018, Justice Bransten of the Supreme Court, New York County, Commercial Division, addressed the enforceability of a liquidated damages clause in a service agreement, holding that the clause was an unenforceable penalty. Perseus Telecom, LTD. v. Indy Research Labs, LLC, 2018 N.Y. Slip Op. 33083(U) (here).

Background

Perseus involved an agreement between Plaintiff, Perseus Telecom, Ltd (“Perseus”), a provider of colocation services, and Defendant, Indy Research Labs, LLC (“Indy”), a quantitative trading firm reliant on colocation venders to provide and manage its network and computer infrastructure.

In August 2015, Indy and Perseus began negotiating a “Service Order Form” agreement, which itemized the colocation services that Perseus was to provide, and the related onetime expenses and monthly reoccurring fees. Pursuant to the terms of the Service Order Form, Perseus agreed to provide 36 months of colocation services, and Indy agreed to pay for monthly reoccurring fees for the service. Indy also agreed to pay for non-reoccurring expenses.

At or about the same time, Indy and Perseus also began negotiating the terms of a “Master Service Agreement.” On August 12, 2015, Perseus sent Indy a draft Service Order Form, which referenced and incorporated the terms of the proposed Master Services Agreement. The “Approval” section of the Service Order Form stated that Indy agreed to the terms of the Master Services Agreement. However, if there was a conflict between the Service Order Form and the Master Services Agreement, the terms of the Service Order Form controlled. Indy informed Perseus that, while it could agree to the Service Order Form, it could not agree to the terms of the Master Services Agreement, as drafted, because it believed the terms of the Master Services Agreement were too favorable to Perseus.

Since Indy and Perseus wanted to start work on the project, but could not come to an immediate agreement regarding the terms of the Master Services Agreement, Indy and Perseus agreed to add language to the Service Order Form that, in substance, made the Service Order Form  a “binding commitment” on Indy “to (a) pay Perseus the non-recurring charge for (i) the Servers (and any related infrastructure) to be procured by Perseus on Customer’s behalf and (ii) any Professional Services delivered by Perseus in anticipation of delivery of the Services, in each case as provided in the Service Order Form, and (b) to negotiate in good faith to expeditiously negotiate the final terms and conditions of the [Master Services Agreement], related Service Schedules and Statement of Work referred to above (the “Services Documents”).”

On August 31, 2015, Mitch Sonies (“Sonies”), Indy’s managing member, signed the Service Order Form on behalf of Indy, and returned the Service Order Form to Perseus.

According to Sonies, during September and October 2015, it became clear that Perseus could not meet the deadline it had initially promised. Consequently, on October 30, 2015, Sonies advised Anthony Gerace, Perseus’s president of global sales, that Indy had decided not to go forward with the colocation services under discussion.

On November 6, 2015, Indy confirmed its earlier advice that it was not going forward with the Service Order Form. Approximately two weeks later, on November 23, 2015, Sonies re-confirmed Indy’s decision that it was not moving forward with Perseus. Nevertheless, Sonies indicated that Indy was willing to pay Perseus for the work it performed up to that date, and for eight servers that were called for in the implementation plan, if already purchased by Perseus.

On November 24, 2015, Perseus sent Indy an invoice, in the amount of $193,036.24, for work performed through November 30, 2015, and for hardware procured. Indy did not pay the invoice.

On January 29, 2016, Perseus sent Indy a Notice of Breach, claiming that, pursuant to the terms of the Master Services Agreement, non-payment was considered a voluntary termination of the contract, and that as such Indy was liable for 100% of the amount due under the agreement, to wit, $1,250,650.

On June 22, 2016, Perseus sued Indy seeking payment of $1,250,650. In its complaint, Perseus alleged that on August 31, 2015, Indy and Perseus entered into the Service Order Form and Master Services Agreement, which constituted a single agreement, and that Indy agreed to the terms set forth in those documents. Perseus’s first cause of action alleged that Indy breached the terms of the Service Order Form and the Master Services Agreement when it refused to pay Perseus’s invoices for the services performed. Perseus claimed that under the Master Service Agreement it was entitled to liquidated damage of $1,250,650, representing 100% of the contract fees that would have been paid over the 36-month contract term. In its second cause of action for breach of contract, Perseus alleged that Indy breached the terms of the Master Services Agreement when it failed to provide the written notice of termination required under the agreement. Therefore, under the Master Service Agreement, Perseus was entitled to $1,250,650. In its third cause of action, Perseus alleged that it remitted invoices to Indy, which Indy did not pay; therefore, Indy’s action deprived Perseus of the right to receive benefits under the Service Order Form and the Master Services Agreement. Perseus alleged that Indy breached the covenant of good faith and fair dealing, which resulted in Perseus being damaged in the amount of $167,358.22, the amount of the equipment purchased by Perseus and the third-party services it paid for in performing its obligations under the Service Order Form and Master Services Agreement.

The Court’s Decision

The Court found that Perseus “properly alleged two claims for breach of contract.” However, the Court declined to find a breach of the Master Service Agreement.

While Perseus has properly alleged two claims for breach of contract, the documentary evidence submitted by Indy contradicts Perseus’s claims that the Service Order Form, incorporating the Master Services Agreement, became a binding agreement to purchase 36 months of colocation services. In fact, the documentary evidence conclusively establishes that the Defendant never agreed to the Master Services Agreement and that it was never incorporated into the Service Order Form.

The Court explained that Perseus and Indy agreed that the provisions of the Service Order Form constituted the “only” binding commitment between the parties. The documentary evidence, reasoned the Court, conclusively established that the conditions set forth in the Service Order Form were not satisfied as Indy declined to continue to use the colocation services prior to their delivery. Thus, said the Court, absent fulfillment of this condition precedent, Indy’s obligation to purchase Perseus’s colocation services, pursuant to Perseus’s standards terms and conditions, was not triggered.

The Court also held that Perseus was not entitled to liquidated damages for Indy’s alleged breach. In this regard, the Court found that “[u]nder the express terms of the Service Order Form, Indy is only responsible for paying the non-recurring charges for the servers (and any related infrastructure) procured by Perseus on Indy’s behalf, and for any professional services delivered by Perseus in anticipation of delivery of the Services, the amount of which is to be determined in this litigation.” Since the Service Order Form appended a fee schedule for the cost of the colocation services to be provided by Perseus, the non-recurring charges were “readily ascertainable.” For this reason, the Court concluded that the liquidated damages clause was unenforceable as a penalty.

Here, the liquidated damages clause of the Master Services Agreement is unenforceable because it is a penalty. Since the cost of the colocation services to be provided by Perseus is readily ascertainable from the fee schedule attached to the Service Order Form, Perseus cannot claim that its damages were impossible to determine at the time it and Indy executed the Service Order Form. Further, the liquidated damages amount is $1,250,650, when Perseus’s actual damages are approximately $170,000. Notably, the liquidated damages amount is more than seven times that of Perseus’s actual damages.

Takeaway

Liquidated damages clauses can be found in a wide array of commercial contracts. While such provisions are generally enforceable under New York law, New York courts will nullify them when the amount liquidated bears no relation to the non-breaching party’s actual damages (i.e., the damages constitute a penalty) or where the damages are readily ascertainable. Thus, parties negotiating a contract should consider whether a liquidated damages clause is reasonable and appropriate under the circumstances. As Perseus teaches, New York courts will not hesitate to strike down such provisions where the clause penalizes the party alleged to have breached the agreement.

Tagged with: Breach of Contract, Business Litigation, Commercial Litigation, Contract, Liquidated Damages