The enforceability of liquidated damages

Is the liquidated damages clause in the Agreement of Sale enforceable?

To be clear, the liquidated damage clause at issue in this article is the liquidated damage clause found in paragraph 26(G) of the Agreement of Sale.  The answer is, as is so commonly the case in questions of the law, it depends.

Pennsylvania courts have decided that when a liquidated damage clause is tantamount to a penalty, the clause is unenforceable.  In order to be enforced, the liquidated damage must be a reasonable forecast of the potential harm to the non-breaching party.  The benefit of having a liquidated damages clause is that it should limit litigation over damages and allows the parties a degree of certainty when entering into the contract. While courts strive to enforce the intent of the parties to these contracts for that very reason, courts will not enforce a clause that amounts to a penalty and is essentially unfair to one side.

Courts that have reviewed liquidated damages clauses have applied a five-part test to determine if the liquidated damages are in fact a penalty and therefore, unenforceable.

The courts look at:

1. the language of the contract
2. the intentions of the parties
3. the subject of the contract and its surroundings
4. the ease or difficulty in measuring the amount of damages
5. the sum stipulated.

It is unlikely that your average residential buyer or seller considers all of these elements when entering into the Agreement of Sale.  Fortunately, courts that have ruled on the enforceability of the liquidated damages, in the real estate setting, have primarily focused on the ratio between the liquidated damage and the amount of the deposit being held as the liquidated damage.  Specifically, in real estate transactions, courts have held that where the liquidated damage is equal to between 9 to 11 percent of the purchase price the liquidated damage is a reasonable forecast of the potential harm and is enforceable. On the other hand, a court held that a liquidated damage that amounted to 60 percent of the purchase price was not reasonable and was found to amount to a penalty and was unenforceable.

The court has stated that real estate transactions are within the class of cases where the amount of damages for a breach in performance is difficult to determine. It is for that very reason, that Agreements of Sale for real estate include liquidated damages clauses to cover a buyer’s breach.  In the current real estate market, the amount of the deposit paid by buyer may be insufficient to cover the actual damages incurred. Frequently deposits of $500.00 to $2,500.00 are tendered as deposit money, regardless of the purchase price of the property.

Although Pennsylvania Courts have not considered the question of an insufficient liquidated damage, courts in other states have found that in the absence of fraud, duress or unconscionability, liquidated damages provisions are not subject to challenge based on the allegation that the liquidated damage is inadequate to compensate for the damages actually incurred.  The lesson here is that if you anticipate substantial damages, then you might negotiate for a deposit that ranges between 9 to 11 percent of the purchase price.

In the alternative, and rather than accept an insufficient deposit that is the limit of seller’s recovery, remove the check-mark that makes the deposit a liquidated damage.  In that way, a seller may endeavor to recover actual loses in the event of the buyer’s default.

This article was co-authored by James Goldsmith, Esquire.