Liquidated Damages Clause Found Not to Be Unconscionable

• Posted on: Jul 19 2021

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.”).

[This Blog wrote about liquidated damages here, here, and here.]

Are Liquidated Damages Clauses Enforceable?

Unconscionability

Like any provision in a contract, a liquidated damages clause is unenforceable when it is unconscionable. Gillman v. Chase Manhattan Bank, 73 N.Y.2d 1, 10 (1988). An unconscionable contract is one that “‘is so grossly unreasonable or unconscionable in the light of the mores and business practices of the time and place as to be unenforcible according to its literal terms.’” Id. (quoting Mandel v. Liebman, 303 N.Y. 88, 94 (1951) (citing 1 Corbin on Contracts, § 128, p. 400)). “The doctrine, which is rooted in equitable principles, is a flexible one and the concept of unconscionability is intended to be sensitive to the realities and nuances of the bargaining process.” Id. (quoting Matter of State of New York v Avco Fin. Serv., 50 N.Y.2d 383, 389-390 (1980)) (internal quotation marks omitted). “A determination of unconscionability generally requires a showing that the contract was both procedurally and substantively unconscionable when made — i.e., some showing of an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.” Id. (quoting Williams v Walker-Thomas Furniture Co., 350 F.2d 445, 449 (D.C. Cir. 1965) (internal quotation marks omitted) and citing Avco Fin. Serv., 50 N.Y.2d at 389).

“The procedural element of unconscionability requires an examination of the contract formation process and the alleged lack of meaningful choice.” Gillman, 73 N.Y.2d at 10-11. Among the factors considered by the courts are “the size and commercial setting of the transaction …, whether deceptive or high-pressured tactics were employed, the use of fine print in the contract, the experience and education of the party claiming unconscionability, and whether there was disparity in bargaining power.” Id. at 73. N.Y.2d at 11 (citations omitted).

Substantively, unconscionability requires and examination of the substance of the bargain “to determine whether the terms were unreasonably favorable to the party against whom unconscionability is urged. Id. at 73. N.Y.2d at 12 (citations omitted). Typically, the terms of the contract are so outrageous as to be deemed substantively unconscionable.  Examples of substantively unreasonable contractual provisions include, but are not limited to, inflated prices, unfair termination clauses, unfair limitations on consequential damages and improper disclaimers of warranty. State v. Wolowitz, 96 A.D.2d 47, 67-68 (2d Dept. 1983). In determining the conscionability of a contract, no one factor is weighted over another; “each case must be decided on its own facts.” Id. at 68. (citing Matter of Friedman, 64 A.D.2d 70, 85 (2d Dept. 1978). 

In general, “procedural and substantive unconscionability operate on a ‘sliding scale’; the more questionable the meaningfulness of choice, the less imbalance in a contract’s terms should be tolerated and vice versa.” Id. (citation omitted). “While there may be extreme cases where a contractual term is so outrageous and oppressive as to warrant a finding of unconscionability irrespective of the contract formation process …, such cases are the exception.” Id. (citation omitted). Generally, the party claiming unconscionability must show both a lack of a meaningful choice and the presence of contractual terms that unreasonably favor one party over the other. Id. (citing Avco Fin. Serv., supra). 

Notwithstanding the foregoing, courts are reminded that contracts “essentially involve[] a bargained-for exchange between the parties” and “[a]bsent some violation of law or transgression of a strong public policy, the parties to a contract are basically free to make whatever agreement they wish, no matter how unwise it might appear to a third party.” Id. (citing Rowe v. Great Atlantic & Pacific Tea Co., 46 N.Y.2d 62, 67-68 (1978)). “The doctrine of unconscionability, with its emphasis on the contract-making process, is really an expression of, rather than an exception to, this principle. By focusing on the manner in which a contract is entered into and the status of the parties, the doctrine is designed to insure freedom of contract and not to negate it.” State, 96 A.D.2d at 68.

Whether a contract or a clause therein is unconscionable is generally an issue of fact requiring a hearing and the presentation of evidence. Wilson Trading Corp. v. David Ferguson, Ltd., 23 N.Y.2d 398, 403 (1968). Thus, if it appears from the record that unconscionability may exist, and the issue is not free from doubt, then the court must hold a hearing where the parties may present evidence with regard to the circumstances of the signing of the contract, and the disputed terms’ setting, purpose and effect. State, 96 A.D.2d at 60 (citations omitted).

A Penalty

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).

Other than unconscionability, 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).

Against the foregoing legal discussion, we examine Rome Gas, Inc. v. Fastrac Props. I, LLC, 2021 N.Y. Slip Op. 04451 (4th Dept. July 16, 2021) (here). Rome involved a liquidated damages clause in a real estate purchase agreement (“REPA”) that was claimed to be unconscionable.

Rome Gas, Inc. v. Fastrac Props. I, LLC

In Rome, Plaintiff claimed that defendant breached the REPA and, as a consequence, sought specific performance and monetary damages. 

The REPA contained a liquidated damages provision, which stated in part: “In the event the Agreement is not closed due to the fault of the Seller [i.e., defendant], the money paid in escrow shall be returned to the Purchaser [i.e., plaintiff]. In such event neither party shall have any further claim against the other.” Plaintiff appealed from an order that granted defendant’s motion for summary judgment limiting damages on the first cause of action to the amount paid in escrow pursuant to the liquidated damages provision and dismissing the second and third causes of action in their entirety. Plaintiff claimed that the liquidated damages clause was unconscionable and therefore unenforceable. The Appellate Division, Fourth Department rejected plaintiff’s contention. 

The Court found that the REPA was not procedurally unconscionable given that it was “entered into by sophisticated entities as part of a normal commercial transaction, there [was] no evidence of deceptive or high-pressure tactics, [the] agreement contain[ed] [no] ‘fine print,’ and there was no disparity in bargaining power.” Slip Op. at *1 (internal quotation marks omitted) (quoting Mazursky Grp., Inc. v. 953 Realty Corp., 166 A.D.3d 432, 433 (1st Dept. 2018)). The Court also rejected plaintiff’s contention that the REPA was procedurally unconscionable because plaintiff “was not initially represented by counsel.” Id. The Court noted that once plaintiff retained counsel, plaintiff “never objected to the liquidated damages provision” even though plaintiff “sought to amend various … provisions of the REPA.” 

The Court also found that in “[c]onsidering the context, the purpose and the effect of the [liquidated damages] provision,” it was not “substantively unconscionable.” Id. (citations omitted). 

Takeaway

Liquidated damages clauses are frequently challenged as a penalty by one party against another. Rome shows, however, that the doctrine of unconscionability can be used as an additional basis upon which a party can challenge the enforceability of a liquidated damages clause.