Article | Remedies
An Empirical Study of the Enforcement of Liquidated Damages Clauses in California and New York
by Luca S. Marquard*
From Vol. 94, No. 3
94 S. Cal. L. Rev. 637 (2021)
Keywords: Liquidated Damages, Penalty Clause, California Law, New York Law
A liquidated damages provision is a contract clause that predetermines the measure of damages in case a party breaches an agreement. Liquidated damages clauses are among the most commonly used contract clauses and are standard practice in most commercial agreements.1 Parties typically include such clauses in their contracts in an attempt to minimize anticipated litigation time and cost and to avoid the unpredictability of courts’ damages calculations. The renegotiation leverage gained from a liquidated damages clause provides incentive for a party to bargain for the inclusion of such a clause, especially if the party considers itself likely to be the nonbreaching party in any potential dispute. However, in reality, the security parties get from including a liquidated damages clause in their agreement is far from absolute. While certain types of liquidated damages clauses are more likely to be enforced than others, these clauses cannot confidently be relied on by practitioners. Despite a common perception to the contrary, this Note will show that such unreliability exists across jurisdictions.
American courts distinguish between valid liquidated damages clauses and penalty clauses. Simply put, a valid liquidated damages clause compensates the nonbreaching party in the case of breach, while a penalty clause, as its name suggests, penalizes the breaching party and by its coercive nature serves to induce performance.2 The distinction between these two clauses, which is often difficult to make, is an important one: while liquidated damages clauses are enforceable, penalty clauses are unenforceable as being against public policy.3 Whether courts should continue to follow this distinction has been the subject of extensive scholarly debate. Rather than adding another voice to the clamor, this Note will take the current distinction between liquidated damages and penalty clauses as given.
Instead, this Note will examine and compare how courts in New York, the most important American contract law jurisdiction,4 and in California, the state with the largest economy,5 have applied the distinction in recent years. This Note will discuss trends in enforcement and reasoning gleaned from the detailed study of over fifty of the latest court decisions on the enforceability of liquidated damages clauses in each California and New York. In doing so, this Note will test the validity of two hypotheses. The first hypothesis is that courts across jurisdictions are more likely to enforce liquidated damages clauses if the parties to the agreement are sophisticated. The second hypothesis is that New York courts are more likely than California courts to enforce liquidated damages clauses, and that this difference is most pronounced in consumer contracts.
Part I of this Note will provide an overview of the policy debate regarding whether the law should distinguish between liquidated damages clauses and penalty clauses and thus refuse to enforce penalty clauses. This Part will explain the most important arguments both in favor of and against enforcing penalty clauses and point out an argument regarding the theoretical foundation of liquidated damages.
Part II of this Note will describe the current state of the law of liquidated damages, articulating both the formal doctrine and how recent cases have interpreted it. This Part will outline the research methodology used for this project, give an account of first California and then New York law, before making a preliminary comparison of the approaches taken in the two jurisdictions.
Part III of this Note will discuss current trends in the enforcement of liquidated damages clauses in both California and New York, addressing characteristics of common transaction and clause types.
Part IV of this Note will analyze the importance of parties’ sophistication and the negotiation process to courts’ decisions on the enforceability of liquidated damages clauses.
This Note will make two significant contributions to the legal scholarship in this area. First, by describing the findings of an extensive empirical case survey, this Note will provide practitioners with an on-the- ground view of how courts actually treat liquidated damages clauses. This will give attorneys and their clients a better understanding of whether to include liquidated damages clauses in their agreements, how to phrase them, and, when considering breaching an agreement, whether a clause is likely to be enforced.
Second, this Note will ultimately draw several significant conclusions from this empirical analysis. The first being that there is no significant difference between California and New York courts’ treatment of liquidated damages clauses. Courts in both jurisdictions are more likely to enforce liquidated damages clauses in agreements between sophisticated parties. Further, there is no significant difference between how California and New York courts enforce liquidated damages clauses, both generally and against consumers and unsophisticated parties. This Note argues that this is due, at least in part, to the importance of sophistication and negotiation in courts’ determination of the enforceability of liquidated damages clauses. The absence of a significant difference between California and New York courts’ enforcement of liquidated damages clauses calls into question the widely held belief that New York courts take a formalist approach to contract law and that this makes New York an appealing jurisdiction for parties to business contracts. While New York law is the law of choice for parties to commercial contracts and generally preferred over California law,6 where liquidated damages clauses are concerned, parties choosing New York law likely do not receive the benefits they expect from their choice of law.
*. Senior Editor, Southern California Law Review, Volume 94; J.D. Candidate 2021, University of Southern California Gould School of Law; B.A. Economics 2018, University of California, Irvine. Thank you to Deena and Lora Fatehi for their unwavering support and companionship during the writing process. In addition, thank you to Professor Jonathan Barnett for encouraging me to pursue this topic and for his guidance during the drafting of this Note. Finally, thank you to the talented Southern California Law Review editors for their excellent work.