Liquidated Damages Cannot Penalize

A liquidated damage provision can be an effective contractual tool to predetermine the amount of damages a party must pay if there is a breach of the contract. Liquidated damage provisions are intended to provide parties with certainty of result by allowing them to agree in advance to a sum certain. That sum is intended to be a reasonable estimate of potential damage in the event of a breach. As illustrated by a recent Massachusetts Appeals Court decision, however, a liquidation damage provision that serves as a penalty for a breach of the contract, rather than a reasonable estimate of potential damage, will not be enforced.

The decision concerned a provision of a commercial lease that entitled the tenant to actual damages plus $500 for each day items identified on a punch list, such as HVAC maintenance and repair, remained uncompleted after thirty days. Liquidated damage provisions negotiated between sophisticated parties are presumptively valid, provided that: (1) actual damages are difficult to calculate at the time of contract formation; and (2) the agreed upon sum represents a reasonable estimate of potential damage in the event of a breach. As the Appeals Court noted, however, the provision of this lease was not a liquated damages provision at all. By awarding a sum above the tenant’s actual damages, this provision guaranteed that the liquidated damage calculation would exceed, and perhaps vastly exceed, the actual damage calculation. Rather than provide the parties with certainty of result by allowing them to agree to a sum certain based on a reasonable estimate of potential damages, this lease provision simply added a $500 daily fine to the tenant’s actual damage calculation. The Appeals Court determined that this lease provision was an unenforceable penalty and therefore limited the damages to the tenant’s actual damages.