Liquidated Damages Clause

A clause in a contract for liquidated damages, which is a specified amount or percentage to calculate, for a contractual breach has a long history in California.  Under some circumstances, the provision can be designed and operate as a contractual forfeiture (a rare finding because "the law abhors a forfeiture"). 

California's Civil Code § 1671 places limits on liquidated damages clauses, especially for certain contracts, such as for consumer goods and services, and leases of residential real property. 

A provision for liquidated damages is valid, unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.

A liquidated damages clause will generally be considered unreasonable and unenforceable if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would result from a breach.  The amount specified in the contract must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.

In the standard residential purchase agreement, the liquidated damages clause is in paragraph 21 B,  and it provides that if the buyer fails to complete the purchase because of buyer's default, seller shall retain, as liquidated damages:

            a.         The deposit actually paid, unless

            b.         The property is a dwelling with no more than four units, one of which the buyer intends to occupy, then the amount retained shall be no more than 3% of the purchase price.

            c.          Any deposit in excess of the maximum allowed shall be returned to the buyer.

Any clause in the agreement that specifies a remedy, such as a release or forfeiture of deposit or making a deposit non-refundable, for a buyer's failure to complete the purchase in violation of the agreement is invalid, unless the clause independently satisfies the statutory liquidated damages requirements in the Civil Code. (Paragraph 21 A.)

Because the deposit is limited to 3% for residential homes of 1-4 units in the standard residential purchase agreement, sellers of such properties should always insist on  an initial deposit of 3% of the purchase price to maximize their recovery if there is a breach by the buyer.  For other properties, the seller can attempt to get an increased amount as a deposit in a clause that is part of the agreement, but it has to be reasonable under the circumstances. 

Understandably, buyers would prefer to deposit a sum much less than 3% of the purchase price, or no deposit at all, to minimize their exposure if they breach the contract.

           

A liquidated damages clause is valuable in because it specifies the amount of damages in a breach of contract claim., often leaving only issues of liability to be decided. Consideration should be given to including a liquidated damages clause in every contract as it will simplify determining the amount of damages for any breach.  Typically, it is the seller who benefits from a liquidated damages clause that allows retention of a deposit, but they can be structured as mutual, if it was reasonable for the parties to suffer damages from the breach of the other.

As with most legal matters, it is a best practice to consult with an attorney regarding all contract documents, especially with regard to liquidated damages provisions, in order to avoid expensive lawsuits to resolve contractual disputes.