Wednesday, April 3, 2013

Practice Tip: Don't Call Your Liquidated Damages Clause a "Penalty" In the Contract

Readers of this blog know that I am an advocate of using liquidated damages clauses in non-compete agreements. Though not for every situation, they can help avoid the knotty problem of proving lost profits damages through extensive discovery and use of expert testimony. And they can provide a true remedy for a breach, because often times an injunction won't recapture a lost customer.

In terms of drafting liquidated damages clauses, I have several general rules companies should do their best to abide by:

1. Think through the actual formula used to ensure it's a sound predictor of actual loss.

2. Run through hypotheticals to see how the formula will play out in a potential suit.

3. Avoid using arbitrary, fixed numbers and come up with a methodology that is tied to an objective financial indicator, such as past sales or earnings.

4. Reserve in the liquidated damages clause the ability to seek injunctive relief.

Here's what not to do: Call your liquidated damages clause a "penalty."

Unfortunately, that's what the plaintiff did in Kehoe Component Sales, Inc. v. Best Lighting Prods., Inc., 2013 U.S. Dist. LEXIS 38816 (S.D. Ohio Mar. 20, 2013). At the tail-end of the non-compete (contained in a supply, not an employment, agreement), the agreement stated that "[p]enalties for violation of the non-compete provision shall be the rate of $500,000 per occurrence."

To the court's credit, it did not strike the liquidated damages clauses solely on the basis of the unfortunate verbiage used. Rather, it determined that the arbitrary fixed sum of $500,000 had no relationship to any past sales practice and was a draconian provision intended to secure contractual performance.

But judges are people too, and it's awfully hard to get around the optics of how such a clause looks on paper. Liquidated damages clauses are not always enforceable and won't be honored if they lack a reasonable relation to potential loss (a so-called contractual "penalty"...verboten in all states). Courts do not "punish" a breach of contract because it's not a wrong; an efficient breach of contract is often times a great business decision. A liquidated damages clause, if not thought through, can have the effect of punishing a breach. And courts will strike them if that's the apparent intent.

Particularly when it says so right in the contract.

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