Construction contacts often include provisions that provide for pre-determined or “liquidated” damages in the event of a breach. Such provisions can provide certainty to the parties as to the consequences of a breach and can simplify the task of proving up damages at trial. However, as one contractor found out recently, courts may refuse to enforce liquidated damages provisions if the amount specified is disproportionate to the actual damages (see Smart Construction & Remodeling v. Suchy, 2023 WL 5525071 (Minn. Ct. App. August 28, 2023)).
Smart Construction involved a contract to repair a home in exchange for insurance proceeds. In negotiating the cost of repairs with the insurance company, the contractor submitted an estimate showing that it would receive 10% overhead and 10% profit on the job. After the contractor had reached agreement with the insurance company, the owner elected to forego the repairs. The contractor sued the owner for breach. The contract provided that in the event of a breach by the owner, the contractor would be entitled to 30% of the contract value as liquidated damages. The jury found that the owner breached the contract and awarded the contractor 30% liquidated damages.
The owner moved to set aside the jury’s verdict claiming that liquidated damages of 30% were disproportionate to the contractor’s actual damages, which were at most 20%. The trial court, and later the appellate court, agreed. Under Minnesota law, which is similar to the law in other states, courts refuse to enforce liquidated damages provisions that are punitive rather than compensatory. As the court explained:
The law adopts as its guiding principles that the injured party is entitled to receive a fair equivalent for the actual damages necessarily resulting from failure to perform the contract and no more. Punishment of a promisor for breach, without regard to the extent of the harm that he has caused, is an unjust and unnecessary remedy and a provision having an impact that is punitive rather than compensatory will not be enforced.
Id. at *6. Where the amount of actual damages is susceptible of definite measurement, liquidated damages that are “greatly disproportionate” to actual damages are considered to be a penalty and therefore unenforceable.
Applying these principals, the court held that the contractor’s actual damages were susceptible of definite measurement in that they were at most the 20% overhead and profit figure quoted to the insurance company. The court further held that liquidated damages of 30% – or 50% more than actual damages – was excessive and therefore unenforceable. The court reasoned that “[n]o legitimate purpose is served by the inflated liquidated damages term” and that the excessive amount of liquidated damages “improperly pressures the homeowner to remain in the contract, even if the homeowner does not want to proceed with repairs or disagrees with the repairs or materials as the work and materials are determined in the future.”
Interestingly, the contractor had only claimed liquidated damages – not actual damages. As such, the contractor was left with no remedy for the owner’s breach when the liquidated damages provision was struck down.
Smart Construction is a good reminder that the (1) liquidated damage provision should be crafted to approximate actual damages to the extent possible and (2) litigants should claim actual damages as a fallback in case liquidated damages fall through.