A decision recently issued by Massachusetts' highest court has made a significant change to the manner in which liquidated damages clauses appearing in contracts are interpreted and enforced. This change will have a great influence on how contracts will be negotiated and drafted in the future.
Liquidated Damages Clause
What is a liquidated damages clause? Simply stated, it is a provision in a contract that calls for a certain amount of damages to be paid by a party who breaches a contract. For example, in real estate purchase and sale agreements there is usually a clause which states that in the event that the buyer fails to purchase the property without a valid reason then the seller is entitled to keep the deposit. A similar type of clause can appear in any contract and is common where one of the parties tenders a deposit as earnest money to show a good-faith and economic commitment to the transaction.
Past History
In the past, these liquidated damages clauses did not always operate as they read. In numerous cases, the lower courts would review the contract provisions and determine if the damages were reasonable as anticipated damages as of the time of the contract. Assuming that the court found that the provisions were appropriate at the time of the contract, the court would then take a "second look" to see if the damages provisions were fair and reasonable, using hindsight. In other words, the reviewing court would check to see if the liquidated damages resembled the actual losses suffered by the injured party. If the liquidated damages exceeded the actual loss, then the court would not enforce the contract provisions.
"Second Look" Concept
The recent Supreme Judicial Court decision discarded the "second look" concept. From this time forward, a liquidated damages clause will be enforced if the amount of the liquidated damages is reasonable in light of the information available at the time of the contract. Therefore, parties to a contract must recognize that the deposit funds are now at greater risk of loss in the event of breach.