Liquidated damages clauses are common in many different types of contracts. Such a clause provides that, in the event of breach of the agreement, the non-breaching party is entitled to damages that are specifically enumerated in the agreement. For example, if X breached the agreement, Y is entitled to $100,000.
The idea behind liquidated damages clauses is that they save litigation costs and lessen the uncertainty associated with determining the monetary extent of damages arising from a breach. Liquidated damages clauses are common in the franchise agreements that are the contractual foundations of the hospitality industry.
However, while the clauses are designed to lessen the uncertainty inherent in a contractual relationship, new uncertainties are created in the form of whether a court will enforce a liquidated damages clause. Depending on the agreement, the enforcement of a liquidated damages clause can mean the difference between money in a party's pocket with very little effort versus a protracted and expensive court battle to assign a specific monetary value to a breach.
Whether a liquidated damages clause is enforceable is a matter of state contract law. Therefore, the particulars of when an agreement will, and will not, be enforced can differ from state to state. That said, there are general guidelines that most states follow.
The guidelines
First, liquidated damages are permitted only where calculating the actual damages would be difficult or impossible. Second, the liquidated damages clause must be designed to compensate the non-breaching party, as opposed to merely being a penalty imposed on the breaching party. Third, the damages awarded under a liquidated damages clause must be a reasonable estimate of the potential damages contemplated at the time the contract was formed.
These requirements immediately bring to mind the tension between the first and third elements. If, for example, a court finds that the first element is met because calculating actual damages was impossible, then how can the same court make a determination that the liquidated damages are reasonable because they approximated the estimate of actual damages at the time the contract was formed?
While this seems like a logical disconnect, in practice, if courts find that the first two elements are met, then the third element generally is used simply to determine whether the liquidated damages are reasonable given all the facts and circumstances of the case. In franchising agreements, fixed metrics are often used to calculate liquidated damages.
For example, the liquidated damages may be $500 multiplied by the number of hotel rooms at the breaching party's location, multiplied by the days that the party was in breach. The burden is on the breaching party to convince the court that a liquidated damages clause is a penalty provision, rather than a provision designed to justly compensate the non-breaching party. Moreover, the matter will be determined by the court as a matter of law, meaning that the judge, rather than a jury, will make the ultimate determination.
Case study
A decision issued in April 2014 by the United States Bankruptcy Court for the District of Connecticut provides a real world example of a hotel liquidation clause in action. In In re Whitehall Avenue, LLC, the court presided over a dispute between Best Western International, Inc. and franchisee Whitehall Avenue, LLC.
Whitehall operated a Best Western hotel located in Mystic, Connecticut. Under the franchise agreement between the parties, Best Western would periodically inspect the hotel. After Whitehall failed a series of inspections, Best Western sent Whitehall a notice of termination, dated 9 August 2009. Among other things, the notice of termination required Whitehall to cease using all Best Western symbols and to remove them within 15 days.
Whitehall covered up the exterior Best Western sign, but not until 15 October 2009. In addition, even after 15 October 2009, the tarp used to cover up the exterior sign did not fully obscure an allegedly distinctive curve at the top of the sign cabinet. Whitehall later filed bankruptcy, and Best Western filed a claim in the bankruptcy case for approximately $1.3 million, which was calculated under the liquidated damages clause of the franchise agreement. Specifically, the franchise agreement provided that Best Western was entitled to 15% of the mean of Whitehall's room rates, per room per day, multiplied by the number of rooms (150).
Whitehall argued that the liquidated damages clause was unreasonable and was actually a penalty provision because the calculation did not take into account the hotel's occupancy rates. The Bankruptcy Court for the District of Connecticut analyzed the agreement under the law of Arizona (where Best Western is headquartered), based on the franchise agreement's choice of law provision.
The Bankruptcy Court first considered Best Western's argument that the clause should be enforced because the same clause passed muster in several previous cases before other courts. The Bankruptcy Court found this argument "unavailing" because the enforceability of a liquidated damages clause is very fact specific and depends on the facts and circumstances of the particular case before the court.
However, the Bankruptcy Court also disagreed with Whitehall's argument regarding the hotel occupancy rates. The court noted that a 15% factor was applied to the room rates and also noted Best Western's argument that the liquidated damages were designated to compensate Best Western for losses from Whitehall's unauthorized use of Best Western's symbols, which had nothing to do with occupancy rates. For these reasons, the Bankruptcy Court determined that Whitehall had not met its burden of establishing that the clause was a penalty provision and that Best Western was entitled to its calculation of liquidated damages up to 15 October 2009.
The Bankruptcy Court next turned to Best Western's arguments that it was also entitled to damages following 15 October 2009 based on Whitehall's failure to fully cover the Best Western sign. The Bankruptcy Court noted the difficultly of estimating damages for post-termination damages relating to a franchisee's unauthorized use of symbols. The court further noted an Arizona Court of Appeals decision that a liquidated damages clause may be found reasonable even where there is no showing of actual damages. The Bankruptcy Court went on to note, however, that awarding additional liquidated damages following 15 October 2009—which amounted to additional damages of almost a quarter of a million dollars—would be unreasonable and excessive, given the fact that it was highly unlikely that the exposed part of the sign would confuse the public into thinking that the hotel remained a Best Western. Therefore, the Bankruptcy Court denied Best Western's claim for liquidated damages following 15 October 2009.
The "split the baby" approach taken by the court in the Whitehall case provides useful guidance to parties seeking to defend—or attack—a liquidated damages provision. Courts are likely to enforce clauses that evidence a reasonable deal struck between the parties at the time the agreement was executed. Courts are less likely to enforce clauses based on hypertechnical breaches that did not clearly lead to any damages on the part of the non-breaching parties.
Jason Binford is a director in the Dallas-based law firm of Kane Russell Coleman & Logan PC where he practices in the firm’s Insolvency, Bankruptcy & Creditor Rights section. His experience includes representation of debtors and creditors in large to mid-size Chapter 11 and Chapter 7 cases. He has significant familiarity and expertise in issues unique to vendor creditors, as well as 363 sales, intellectual property, landlord/tenant and franchise issues.
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