January 1, 1900

by Marc H. Herman

Quite often in the conduct of general business, parties choose to enter into agreements which contemplate not only the performance of the agreement, but also the consequences in the event that performance is not rendered by one party or another. In an attempt to avoid or at least minimize litigation in the event of a breach of the contract, a liquidated damages clause, also referred to as a "stipulated damages clause", can be used. When adding such as clause to a contract, parties should ensure that the clause is enforceable for the protection contemplated.

Liquidated Damages Defined

As a general rule, the courts hold that between equally sophisticated parties to a commercial transaction, liquidated damages clauses that set forth stipulated damages can be a "useful and efficient" remedy. Liquidated damages clauses have been defined by the courts as the sum a party to a contract agrees to pay if that party breaks some aspect of the contract. The amount should be based on a good faith effort to estimate in advance the actual damage that will occur as a result of the breach. Courts have found such clauses to be unenforceable when they appear to be drafted in a manner which provides for a penalty as opposed to an actual loss. The Uniform Commercial Code, which governs sales of goods between both commercial and noncommercial parties, recognizes the efficiency of liquidated damages provisions as noted by the New Jersey courts and has provided a statutory basis for the inclusion of such provisions in contracts for the sale of goods.

To ascertain whether such a liquidated damages clause constitutes a permissible forecast of damages rather than an impermissible penalty clause, the courts assess the reasonableness of the clause: According to our New Jersey Supreme Court, "absent concerns about unconscionability, courts frequently need ask no more than whether the clause is reasonable." Assessment of reasonableness requires several inquiries. First, it must be determined whether the harm which would ensue from breach of the contract is incapable or very difficult to accurately estimate. The greater the difficulty in assessing or proving damages, the more likely the clause will be held permissible. Second, there must be a determination as to what was the objective intent of the contracting parties at the time of execution. Whether the clause states within its text it is either a liquidated damages or penalty clause is not dispositive. Quite significantly, when undertaking this assessment of the intent of the parties, the court can perform its review from either the time of the contract execution (prospective) or the time of the breach (retrospective). Where a calculation of the damages after the breach reveals that the amount stipulated to in the contract is unconscionable, the court may strike the clause, notwithstanding the apparent appropriateness of the clause at the time the contract was executed.

Perhaps surprisingly, these guidelines have not often been the subject of litigation in this State. Applying New Jersey's principles regarding liquidated damages in the context of a contract for services, the federal district court in New Jersey has held that liquidated damages amounting to triple the amount of the injury were not by their very nature unreasonable. Specifically, the court did not find that such liquidated damages were either "unconscionable" or a "penalty".

Enforcement Under Appropriate Circumstances

It is clear that the courts will enforce liquidated damages clauses in the appropriate circumstances. In order to adequately achieve this result, the intent of the parties to any agreement which contains such a provision must be adequately documented and reflected in the agreement. Furthermore, the construction of the provision itself must be the product of careful analysis and review of each situation upon its own merits. Only through conscientious drafting and execution, will the parties intentions be effectuated. Thus, parties who wish to pursue this possibility are well advised to seek counsel prior to executing an agreement including such a provision.

Marc H. Herman is an associate of Hill Wallack where he is a member of the Litigation Division and Trial & Insurance Practice Group.