Liquidated damages are unenforceable if they significantly exceed actual damages

March 27, 2020

The Texas Supreme Court recently clarified the law governing enforcement of liquidated-damage provisions in contracts. Even if the liquidated-damage provision was enforceable at the time the parties formed the contract, a court still may compare the actual damages suffered to the liquidated damages to determine whether the provision should still be enforced.

A liquidated-damage provision in a contract sets a fixed amount or formula to be used to calculate damages from a breach. If it is enforced, then the party enforcing the contract will not be required to prove its actual damages from the other party’s breach.

To enforce a liquidated-damage provision, the party enforcing the contract must prove that, at the time the contract was formed: (1) the harm anticipated from a breach was difficult to predict; and (2) the liquidated damage amount was a reasonable estimate of the harm.

The Court explained that a liquidated-damage provision might still be unenforceable even if these two elements are proven. The party breaching the contract may show that the liquidated damages were significantly higher than the actual damages caused by the breach. If so, the liquidated-damage provision constitutes a punishment or penalty, and therefore is unenforceable. In that instance, the party enforcing the contract may recover only its actual damages.

In construction contracts between owners and contractors, liquidated-damage provisions are often used to address damages caused by delays to completion of the project. Applying the Court’s reasoning to these contracts, the owner must show that at the time the contract was signed, it was difficult to estimate the damage that would be caused by a delay. The owner also must provide evidence to show that the amount or formula used for the liquidated damages was a reasonable estimate of the damages. If the owner makes these showings, the contractor would bear the burden to show that the owner’s actual damages resulting from the delays were significantly less than the liquidated damages in order to avoid enforcement of the provision.

Atrium Med. Center, LP v. Houston Red C LLC d/b/a ImageFIRST Healthcare Laundry Specialists, — S.W.3d —, No. 18-0228 (Tex. Feb. 7, 2020).