A common provision in contracts is one for liquidated damages. However, in Massachusetts, courts will scrutinize these clauses to ensure they are reasonable and are not being imposed as a penalty for breaching the contract.
What are Liquidated Damages?
Liquidated damages are a contractually agreed-upon amount to be owed by a party if they breach the contract. An example would be a contract that specifically said, “If Vendor A does not ship the goods by the date specified in this contract, Vendor A will pay $40,000 in liquidated damages.”
Liquidated damage provisions are common in a wide variety of contracts, including:
- Confidentiality agreements
- Non-compete agreements
- Non-solicitation provisions
- Commercial rental agreements
These provisions serve multiple purposes. They:
- Expedite the process of determining how much is owed for breaching the contract by estimating the losses beforehand
- Clarify the rights of the parties
- Make clear to a potentially breaching party what is at stake
- Avoid costly litigation
However, the potential for abusing these provisions is significant. Therefore, Massachusetts state law has rules for them.
Liquidated Damages Must Be a Reasonable Estimate of Losses, Not a Penalty
Parties drafting a contract can abuse liquidated damage provisions by setting the amount extraordinarily high. Many do so not just to collect the exorbitant amount; they also use the provision to deter a breach of contract.
Because this would not be fair to the other party, Massachusetts law refuses to enforce liquidated damage clauses that are punitive to the breaching party. Only liquidated damage clauses that reasonably estimate the losses that the non-breaching party would sustain are enforceable in the state.
Where to draw the line between an amount that is punitive and one that is reasonable, though quite high, is tricky. As explained in a recent case involving liquidated damages, courts enforce these provisions if:
- The true amount of losses resulting from the breach was difficult to pin down when the contract was signed, and
- The amount of liquidated damages represented a reasonable forecast of what would be lost.
It is up to the party who wants to invalidate the liquidated damage provision to disprove either of these factors.
Massachusetts courts look at the circumstances at the time that the contract was formed rather than when it was breached because, while this is more likely to lead to a windfall to the non-breaching party, it more accurately depicts their contractual expectations (Kelly v. Marx, 428 Mass. 877 (1999)).
Massachusetts Business and Contract Lawyers at the Katz Law Group
Liquidated damage provisions can be useful for efficiently enforcing your contracts. However, if you breach a contract, they can also be a significant threat to your business' financial well-being, or to your own if you signed a personal guarantee for your business' obligations.
Call the Massachusetts business attorneys at the Katz Law Group at (508) 480-8202 or contact them online for help in these extremely important situations.