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Liquidated Damages provisions: Enforceable or not?

It is very common for journalists to sign contracts which contain provisions called “Liquidated Damages”, which purport to set forth an amount due to one party in the event of the other’s breach.  Typically, these are construed by management and employee alike as “buy-out” clauses.  Although that construction is not really wrong, it does, to some degree, misstate the purpose of a liquidated damages provision, which is to provide certainty to contracting parties, at the time of contract, when trying to anticipate the damages likely to be borne by a non-breaching party in the event of a later breach.

Hypothetically, in the broadcast context, an employer might hire a new anchorperson for a non-primary show and sign that person to a three-year deal.  They might decide that the liquidated damages should be, for the sake of discussion, $12,000.00 in the event of breach.  This amount is supposed to represent what the parties agree the loss (damages) to the other would be in the event of breach.  Let’s say that, during that three-year term, that employee is heavily marketed by the television station and promoted to be a mainline anchor.  At that point, you can see that $12,000.00 might not accurately reflect the potential damages to the employer if the employee were to breach.  They might, in fact, be much greater.  Still, the employer’s risk is that this talented employee could walk and, per the contract, the most the employer could recover is the “liquidated” damages amount.

Let’s flip this around.  Let’s say the television station hires an anchor and the parties agree to a $12,000.00 liquidated damages provision in the event of breach.  The hire is a disaster.  The anchor cannot read, fails to show up for work, and cannot get along with his or her teammates.  The anchor is then demoted to reporter and assigned to an unpopular shift.  The station has decided they made a mistake and has effectively hidden the anchor in a lesser position, on a less attractive schedule, thereby limiting that employee’s opportunity to grow.  In this case, it seems unfair to make the employee have to pay $12,000.00 to get out of a contract that the employer clearly no longer values the same way it did at the beginning.  Still, the employee feels chained to that job by the “enormity” of that liquidated damages provision.

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In both of these cases, had there been no liquidated damages provision, the parties would go to court, and it is exceedingly likely that the proof would show that the parties would be damaged in ways that varied substantially from the hypothetical $12,000.00 amount.  Each party would have to hire lawyers and put on proof about their value (or lack of value) to the employer.  In the first case, the station would probably be able to show that $12,000.00 is insufficient to make it whole in the event of the employee’s breach, because the station had so much tied to that employee’s image.  In the second case, the station might lose its claim for heightened damages, because the employer had basically invested nothing in the employee and might not be damaged at all if the employee left.

So, why are these provisions built in to all of these contracts, if they often fail to accurately reflect the true damages arising in the event of breach?

Believe it or not, the goal is to create certainty in an uncertain economic relationship.  These provisions are supposed to represent the best we can do to put our arms around the uncertainty that exists in the employment relationship.  Contract damages are not allowed to be punitive (to punish), so liquidated damages that appear to be punitive should not be enforceable.

Here’s what the Restatement (Second) of Contracts § 356 (1981) has to say about liquidated damages:

(1) Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.

(2) A term in a bond providing for an amount of money as a penalty for non-occurrence of the condition of the bond is unenforceable on grounds of public policy to the extent that the amount exceeds the loss caused by such non-occurrence.

To generalize, many, if not most states, have embraced this concept, and will not enforce a liquidated damages provision that is punitive, or unreasonable “in light of the anticipated or actual loss caused by the breach.”

To those based in Tennessee, here’s how our Supreme Court approaches these provisions:

The fundamental purpose of liquidated damages is to provide a means of compensation in the event of a breach where damages would be indeterminable or otherwise difficult to prove. By stipulating in the contract to the damages that might reasonably arise from a breach, the parties essentially estimate the amount of potential damages likely to be sustained by the nonbreaching party. “If the [contract] provision is a reasonable estimate of the damages that would occur from a breach, then the provision is normally construed as an enforceable stipulation for liquidated damages.” However, if the stipulated amount is unreasonable in relation to those potential or estimated damages, then it will be treated as a penalty.

Guiliano v. Cleo, Inc., 995 S.W.2d 88, 98-99 (Tenn. 1999).

For those of you who may be more interested in how this shakes out in Tennessee, you may read further below from the Guiliano opinion.  In essence, Tennessee courts will only look at how the contracting parties estimated their potential loss at the time of contract and will not consider evidence about actual loss.  Apply that to the above two hypothetical scenarios and you can see why these provisions are troublesome.  In Tennessee, they will be enforced if they were reasonable at the time of contract.  So to win a legal dispute about liquidated damages in Tennessee, a litigant would have to prove that the liquidated damages were unreasonable at the time of contract.  Read on and try to remember when you negotiated your deal.  Would you say this accurately reflects the negotiation that occurred?

Although most jurisdictions disfavor the enforcement of penalties under contract law, there is a split in authority on the proper method for determining whether a liquidated damages provision constitutes a penalty. One method, commonly referred to as the “prospective approach,” focuses on the estimation of potential damages and the circumstances that existed at the time of contract formation. Under this approach, the amount of actual damages at the time of breach is of little or no significance to the recovery of liquidated damages. If the liquidated sum is a reasonable prediction of potential damages and the damages are indeterminable or difficult to ascertain at the time of contract formation, then courts following the prospective approach will generally enforce the liquidated damages provision. In contrast, a second approach has developed in which courts not only analyze the estimation of damages at the time of contract formation, but also address whether the stipulated sum reasonably relates to the amount of actual damages caused by the breach. Under this retrospective approach, the estimation of potential damages and the difficulty in measuring damages remain integral factors for the courts’ review. However, as part of that review, the actual damages at the time of breach are also relevant in determining whether the original estimation of damages was reasonable. If the liquidated sum greatly exceeds the amount of actual damages, then courts following this latter approach will treat the estimated sum as a penalty and will limit recovery to the actual damages.

However, we conclude that the prospective approach is the better rule based upon the consideration it affords to the intentions of the parties and to the freedom to contract. When parties agree to a liquidated damages provision, it is generally presumed that they considered the certainty of liquidated damages to be preferable to the risk of proving actual damages in the event of a breach. Liquidated damages permit the parties to allocate business and litigation risks and often serve as part of the contractual bargain. In addition, they lend certainty to the contractual agreement and allow the parties to resolve defaults and other related disputes efficiently, when actual damages are impossible or difficult to measure.

Guiliano v. Cleo, Inc., 995 S.W.2d 88, 100 (Tenn. 1999)