Penalty Provisions and Liquidated Damages Clauses Cut From The Same Cloth

• Posted on: May 22 2023

By: Jeffrey Haber

Commercial contracts typically include a liquidated damages provision that allows for the payment of a predetermined amount of damages in the event of a breach by one of the parties. Courts will sustain such a provision if the liquidated amount is reasonably proportionate to the probable loss and the amount of actual loss is incapable or difficult of precise estimation. If, however, the amount fixed is grossly disproportionate to the probable loss, then the provision amounts to nothing more than a penalty and will not be enforced. 

Similar to a liquidated damages clause is a penalty provision that fixes damages in the event of a breach of the contract. Penalty provisions in a contract are essentially no different from liquidated damages clauses and, therefore, are treated the same regardless of the nomenclature used by the parties. As the New York Court of Appeals stated, “[i]n interpreting a provision fixing damages, it is not material whether the parties themselves have chosen to call the provision one for ‘liquidated damages’ . . . or have styled it as a penalty.”¹ 

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.²

Are Liquidated Damages Clauses and Penalty Provisions 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.³ 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.”⁴ Although the party challenging the liquidated damages provision has the burden to prove that the liquidated damages are, in fact, an unenforceable penalty,⁵ the party seeking to enforce the provision must have been damaged in order for the provision to apply.⁶ The burden is on the party seeking to avoid liquidated damages to show that the stated liquidated damages are, in fact, a penalty.

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.⁷ New York courts often strike liquidated damage clauses when they fail to meet the foregoing.⁸ 

In addition, a liquidated damages clause will not be enforced “if it is against public policy to do so and public policy is firmly set against the imposition of penalties or forfeitures for which there is no statutory authority” based on the principle of just compensation for loss.⁹ 

“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.”¹⁰ 

In Atlantis Management Group II LLC v. Nabe, 2023 N.Y. Slip Op. 02737 (1st Dept. May 18, 2023) (here), the Appellate Division, First Department examined the foregoing principles in affirming the dismissal of a breach of contract claim that was based on an enforceable penalty provision in four similar operating agreements.

Atlantis Management Group II LLC v. Nabe

Atlantis involved four limited liability companies (the “Companies”), each of which operated a gas station in New York City. Plaintiff was an “Investor Member” and defendants Rajan Nabe and Rahul Nabe were the “Managing Member” of the Companies. 

Beginning in 2008, the Companies made monthly profit distributions to plaintiff based on monthly profit and loss statements from gasoline and merchandise sales. Defendants alleged that in 2011, the parties orally agreed (the “Oral Agreement”) that plaintiff would accept a fixed sum of $10,000 each month from the Companies and that defendants were no longer required to provide plaintiff with financial information. Plaintiff disputed whether any financial disclosure could be withheld and asserted that this payment arrangement was to continue until defendants improved their accounting methodology for the Companies.

In 2016, plaintiff verbally and in writing demanded financial statements and an accounting from the Companies, urging that it was entitled to its share of profits. Defendants contended that, pursuant to the Oral Agreement, plaintiff waived its rights to a percentage of profits and to the Companies’ books and records. Plaintiff sent notices of default and notices to cure to defendants for violations of the Companies’ operating agreements (the “Notices”). The Notices further provided that if the defendants failed to cure, then plaintiff would exercise its buy-back rights pursuant to the operating agreements.

Under Section 6.3 of the operating agreements, if, among other things, defendants “[b]reach[ed] any provision of this [operating agreement]”, then plaintiff had the right “to Buy-Back all of the Membership Interests of the Managing Members [i.e., defendants] in consideration for the sum of One ($1.00) Dollar U.S ….” 

In 2017, plaintiff commenced the action, asserting causes of action for (1) an accounting, (2) breach of fiduciary duty against defendants, (3) breach of contract, (4) specific performance (based on the buy-back provision), (5) declaratory judgment (as to ownership of Companies) and (6) fraud.

Defendants moved for leave to amend their answer to assert additional counterclaims based on breach of fiduciary duty relating to 2020 events. Plaintiff opposed the motion and cross-moved for summary judgment on its remaining causes of action.¹¹

The motion court held that plaintiff was entitled to summary judgment as to liability only with regard to its claim for the failure to provide the Companies’ books and records. The motion court dismissed the breach of contract and specific performance claims as they pertained to the buy-back right under Section 6.3 of the operating agreements.

The motion court held that the buy-back clauses were grossly disproportionate, unreasonable, unenforceable penalty provisions. By their terms, explained the motion court, the breach of any provision however trivial triggered “the draconian $1-buy-out consequence without regard to the magnitude of the breach or actual value of the interest surrendered.” The motion court further explained that Section 6.3 “was ‘conspicuously disproportionate to [] foreseeable losses’ because the same drastic remedy applie[d] to an immaterial technical breach as it [did] a material one.”¹² “By punishing any breach, however minor, with forfeiture of valuable interests in exchange for a mere dollar,” concluded the motion court, “the intent of the provision [was] purely punitive.” “In no way was it intended to remotely correspond with the magnitude of any loss or injury,” said the motion court.

Accordingly, the motion court dismissed the causes of action for breach of contract and specific performance and declared that § 6.3 of the operating agreements constituted an unenforceable penalty.

The First Department unanimously affirmed.

The Court held that the motion court “correctly concluded that § 6.3 of the parties’ operating agreements (OAs) … was an unenforceable penalty.”¹³ The Court explained that “Section 6.3 was not a reasonable measure of the anticipated harm arising from a breach but was instead punitive in nature, serving to propel performance by the [defendants] rather than to merely compensate for a loss.”¹⁴ 

Moreover, the Court found that the liquidated amount not only did not bear a reasonable proportion to the probable loss, but the amount of the actual loss could be determined.¹⁵ In fact, noted the Court, “the amount of actual damages was ascertainable, as evinced by the affidavit of plaintiff’s certified public accountant.”¹⁶

“In addition,” said the Court, “the buyback clause in § 6.3 violated public policy, as it grossly overcompensated plaintiff for any loss it may have sustained from a breach of contract.”¹⁷ As such, “the principle that parties have freedom of contract” could “be overridden” by such a “significant countervailing public policy.”¹⁸ 

[Eds. Note: we examined liquidated damages clauses here, here, here and here.]

Takeaway

Atlantis stands as a reminder that the courts of New York will not hesitate to strike a penalty provision or a liquidated damages clause that punishes as opposed to compensates. Atlantis is also notable in that the Court struck the penalty provision as violative of New York public policy. Although parties are free to contract,¹⁹ they may not enter agreements that are unconscionable or contrary to public policy.²⁰ As noted by the First Department, liquidated damages that constitute a penalty, violate public policy and may override this countervailing policy principle.

Footnotes

1. Truck Rent-A-Ctr. v. Puritan Farms 2nd, 41 N.Y.2d 420, 425 (1977).
2. Id. at 424 (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.”).
3. 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).
4. 172 Van Duzer Realty Corp. v. Globe Alumni Student Assistance Ass’n, Inc., 24 N.Y.3d 528, 536 (2014).
5. JMD Holding Corp. v. Congress Fin. Corp., 4 N.Y.3d 373, 380 (2005); Parker v. Parker, 163 A.D.3d 405, 406 (1st Dept. 2018).
6. See, e.g., J. Weinstein & Sons, Inc. v. City of New York, 264 App. Div. 398, 400 (1st Dept.) (“The proof establishes that no claims were made against defendant and that defendant suffered no financial damage whatsoever”), aff’d, 289 N.Y. 741 (1942).
7. Truck Rent-A-Ctr., 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, 4 N.Y.3d at 380.
8. 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 the time of the breach); LeRoy v. Sayers, 217 A.D.2d 63, 69-70 (1st Dept. 1995) (invalidating lease term in which the tenant forfeited $63,500 in deposits regardless of whether the tenant terminated agreement with several months’ notice).
9. Truck Rent A-Ctr., 41 N.Y.2d at 424; Beltway 7 Props., Ltd. v. Blackrock Realty Advisors, Inc., 167 A.D.3d 100, 106-107 (1st Dept. 2018); Matter of Krodel v. Amalgamated Dwellings Inc., 166 A.D.3d 412, 414 (1st Dept. 2018) (parties may contract for attorneys’ fees so long as they are not in the nature of a penalty or forfeiture).
10. Brecher v. Laikin, 430 F. Supp. 103, 106 (S.D.N.Y. 1977) (citations omitted).
11. Plaintiff was awarded partial summary judgment on its accounting claim.
12. Citing, JDM Holding Corp., 4 N.Y.3d at 380.
13. Slip Op. at *1.
14. Id.
15. Id. (citing, Trustees of Columbia Univ. in the City of N.Y. v D’Agostino Supermarkets, Inc., 36 N.Y.3d 69, 75 (2020)).
16. Id.
17. Id. (citing, New England Mut. Life Ins. Co. v. Caruso, 73 N.Y.2d 74, 81 (1989)).
18. Id. (citing, 172 Van Duzer Realty., 24 N.Y.3d at 536).
19. Freedom of contract is a “deeply rooted” public policy of the State of New York (159 MP Corp. v. Redbridge Bedford, LLC, 33 N.Y.3d 353, 359 (2019); see also New England Mut. Life Ins. Co. v Caruso, 73 N.Y.2d 74, 81 (1989)) and a right of constitutional dimension (U.S. Const, art I, § 10(1)). New York courts have long deemed the enforcement of contracts according to the terms adopted by the parties to be a pillar of the common law. Id. Thus, “[f]reedom of contract prevails in an arm’s length transaction between sophisticated parties …, and in the absence of countervailing public policy concerns there is no reason to relieve them of the consequences of their bargain.” Oppenheimer & Co. v. Oppenheim, Appel, Dixon & Co., 86 N.Y.2d 685, 695 [1995]). “By disfavoring judicial upending of the balance struck at the conclusion of the parties’ negotiations, [New York] public policy in favor of freedom of contract both promotes certainty and predictability and respects the autonomy of … parties in ordering their own business arrangements.” 159 MP Corp., 73 N.Y.2d at 359-360.
20. Truck Rent-A-Ctr., 41 N.Y.2d at 424 (citing, Mosler Safe Co. v. Maiden Lane Safe Deposit Co., 199 N.Y. 479, 485 (1910)).

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.