Agreed damages provisions are a staple of many commercial contracts. But as noted in a previous post to Weil’s Private Equity Insights blog, their enforceability is frequently questioned because of the common law’s requirement that the damages payable for breach of contract not exceed the amount required to compensate the non-breaching party for the foreseeable losses it actually sustained by virtue of the breach. Accordingly, agreed damages provisions are subject to extra scrutiny to ensure they are consistent with the common law’s abhorrence of any contractual provision designed to deter (or punish) a breach, rather than simply ensure that the non-breaching party obtains compensation for its actual loss in the event of a breach. So, when is a contractual provision specifying an agreed amount to be paid by a breaching party to a non-breaching party an enforceable liquidated damages provisions as opposed to a penalty?

In most U.S. jurisdictions, “a liquidated damages clause is enforceable only if ‘the harm caused by the breach [of the contract] is incapable or difficult of estimation and … the amount of the liquidated damages [specified in the contract] is a reasonable forecast of just compensation.’” While England, the birthplace of these common-law principles, has recently moved away from requiring that agreed damages provisions constitute a legitimate pre-estimation of actual damages as a condition to their enforceability, that requirement continues to occupy courts in the U.S. And determining when an agreed damages provision is a legitimate pre-estimate of anticipated actual losses (which are “incapable or difficult of estimation”) is understandably fraught with uncertainty.

The Arizona Supreme Court was recently faced with just such a determination in Dobson Bay Club II DD, LLC v. La Sonrisa de Siena, LLC, 393 P.3d 449 (Ariz. 2017).

Dobson Bay involved the enforceability of an agreed damages provision specifying that a borrower was required to pay a lender a late fee of 5% of a balloon principal payment on a loan to the extent such payment was not paid when due. The 5% late fee was in addition to charges for default interest and collections costs. The late fee provision under consideration read as follows:

If any installment payable under this Note (including the final installment due on the Maturity Date) is not received by Lender prior to the calendar day after the same is due … Borrower shall pay to Lender upon demand an amount equal to the lesser of (a) five percent (5%) of such unpaid sum … to defray the expenses incurred by Lender in handling and processing such delinquent payment and to compensate Lender for the use of such delinquent payment …

Subject to applicable usury laws, the lender could have obviously charged a larger amount of default interest and presumably avoided the question of whether this provision was enforceable. The court did not consider this provision as simply providing additional interest charges for the unpaid principal balance, but instead treated this provision as an agreed damages clause, the enforceability of which was dependent upon whether the amount specified was a legitimate pre-estimation of the actual losses the lender would sustain from the late payment. And the drafting specified that the fee was specifically payable to “defray the expenses incurred by Lender in handling and processing such delinquent payment and to compensate Lender for the use of such delinquent payment.”

In finding the late fee unenforceable, the court took the traditional approach of determining whether the agreed damages had any real relationship to actual, anticipated losses that would be incurred in the event of a breach, and the court concluded that they did not. But the language in the clause that specified what damages and costs the late fee was intended to compensate for ended up limiting the consideration of the potential losses that could have otherwise been considered in determining whether the amount was a legitimate pre-estimation of actual damages. Indeed, the court concluded that that the late fee “either duplicated other fees triggered by a default or was grossly disproportionate to any remaining sums needed to compensate for the anticipated losses identified in the late fee provision.”

While other courts have upheld agreed late fees as enforceable liquidated damages for “lost opportunity costs” occasioned by the late payment, the Arizona Supreme Court found that the explicit recitation of costs of “handling” and “use of such delinquent payment” limited the losses that could be considered in determining the reasonableness of the agreed amount. Thus, the lender’s inability to recover liquidated damages from the borrower in this case turned on the drafting of the contract provision. First, the contract limited what losses the fee would cover by listing two specific types of loss, which the court then exclusively considered when deciding if the 5% late fee was reasonable compensation to the non-breaching party. Additionally, the monetary damages for those two types of loss were quite predictable and generally easy to measure. This restrictive drafting choice prevented the court from determining that either (1) the late fee was reasonable in light of a broad range of other potential losses, or (2) the damages the non-breaching party suffered were unpredictable and hard to measure, and therefore, the parties needed latitude when setting an amount.

This case presents an important practical reminder: practitioners seeking to ensure that agreed damages provisions are enforceable should avoid limiting the items of loss for which the agreed damages are providing compensation and constitute a legitimate pre-estimation. All reasonably foreseeable general or consequential damages that are otherwise recoverable for breach of contract are subject to being pre-estimated and agreed as liquidated damages subject to the traditional rules governing the enforceability of such provisions. Don’t make the enforceability of these provisions even more difficult by limiting the damages that the agreed damages are intended to cover.