Most businesses utilize form documents with customers, suppliers or vendors developed and obtained from different industry sources over time. While form documents are good reference points, the agreements should be reviewed to ensure the terms are internally consistent and comply with Arizona law. Often, we find provisions which are ambiguous, have undefined terms or are unenforceable. While this article focuses on liquidated damages provisions, other contract provisions that warrant further analysis include agreements to agree, restrictive covenants and indemnification provisions.
Compensatory Damages v. Punitive Damages
The general principle governing damages for breach of contract is that the non-breaching party is entitled to compensatory damages which arise naturally from the breach, or which may reasonably had been within the contemplation of the parties at the time they entered the contract. Punitive damages are not available in a breach of contract action absent some type of tort action such as fraud or misrepresentation.
In a breach of contract action, the plaintiff bears the burden of proof to demonstrate that the breach proximately caused the damage and the amount of the loss can be reasonably ascertained. Loss of profits or loss of goodwill may be recovered as contract damages, provided they may be determined by reasonably certain proof.
Business contracts often include a provision which attempts to fix the amount of the damages in the event of a breach because damages are difficult to ascertain. Arizona courts have held that fixed liquidated damages amounts are enforceable if, and only if, they represent a fair estimate of the actual damages. Otherwise, they are treated as unenforceable penalties, as was the case in the 2022 Arizona Court of Appeals case Young v. Allen Homes. In that case, the court noted that liquidated damages provisions are enforceable if they are intended to compensate the non-breaching party rather than penalize the breaching party.
Drafting Liquidated Damages Provisions
When damages are difficult to ascertain, it is beneficial to include a fixed liquidated damages provision in the contract. This way, the parties understand and can agree on how damages will be calculated without having to prove actual damages. Because an arbitrary or flat amount will likely be deemed punitive, or at least require the non-breaching party to prove actual damages, it is advantageous to the business to draft the agreement in a way that is compensatory. Determining actual damages that may be caused by a breach in advance and establishing a formula or calculation that compensates the business increases the likelihood that the provision will be enforced. The amount should reflect material factors attributable to the specific contract. For example, a service contract should not include a flat amount for a delay in performance, but should include a daily default rate for delays which compensate the non-breaching party for payroll costs, including overtime and benefits, inventory restocking expenses, bonding and insurance expenses, equipment rental, loss of income, etc. The key is determining how the business will actually be damaged and then defining a reasonable way to apportion that damage.
Other Takeaways for Drafting Liquidated Damages Provisions
1. Do not call liquidated damages amounts a “penalty” in a contract. While not inherently fatal, it is not helpful.
2. Tailor liquidated damages to be more “directly proportional” to the harm caused by a breach. Fixed flat fees are less likely to be upheld. Daily liquidated damages amounts should be proportional to the actual damage caused. To be upheld, anticipated damages should vary with the nature and extent of the breach. For example, a breach for one day should be more than a breach for several months.
3. To be enforceable, the liquidated damages amount should not be a number arbitrarily set forth in a contract. It is suggested to pencil-out the anticipated losses (i.e.: daily rent on a building that cannot be opened on time) and that flat figures and round numbers are easily challenged provisions. In essence, it is advised to “show your work” when drafting liquidated damages provisions, thus clearly outlining how the aggrieved party will be damaged.
4. Keep close track of actual damages upon a default! The reason for this is: (a) proving actual damages supports the application of a liquidated damages provision; and (b) actual damages can be proved in the event a liquidated damages provision is questioned or struck down.
Having your business contracts reviewed by counsel is helpful to avoid pitfalls and increase the likelihood that your contract terms will be enforceable. To schedule a review, just give us a call.
