When creating a contract, the drafter must always consider how to protect itself in the event that everything goes wrong. After all, those drafting contracts should be preparing for these adverse outcomes that may result, rather than simply engaging in a corporate formality. The primary concern here is often how do I get paid for the goods or services that I provided when the other party breaches the contract. In many cases, breached contracts have a clear value, but in scenarios where damages are more difficult to predict, a party may opt to use a liquidated damages provision.
Actual vs. Liquidated Damages:
While contracts can be enforced after a breach for the amount of actual damages, liquidated damages anticipate more difficult to calculate damages. Where the damages cannot easily be predicted, parties may select a method for calculating damages when entering into the contract rather than calculating the damages that occurred. South Carolina Code Ann. § 63-2-718(1) states that
“[d]amages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty.
Under South Carolina law, “[p]arties to a contract may stipulate as to the amount of liquidated damages owed in the event of nonperformance. Lewis v. Premium Inv. Corp., 351 S.C. 167, 172, 568 S.E. 2d 361 citing Tate v. LeMaster, 231 S.C. 429, 99 S.E. 39 (1957). “Where, however, the sum stipulated is plainly disproportionate to any probable damage resulting from breach of contract, the stipulation is an unenforceable penalty.” Id.
Avoiding Penalties in Liquidated Damages:
In line with these laws above, the majority of liquidated damages provisions create some form of sliding scale based on the percent of the services already rendered. It may also be a fixed sum in particular scenarios; however, the drafter must be careful to set a reasonable amount that can be shown to reflect the anticipated harm. When these liquidated damages provisions set damages in a fashion that cannot possibly reflect the actual damages suffered, the provisions become at risk of being declared a “penalty” that is unenforceable should the contract be the subject of litigation.
The idea of differentiating between probable damages and penalties has been the point of dispute in litigation regarding liquidated damages provisions and led the South Carolina Supreme Court to create the following dispositive test in Tate v. LeMaster:
Implicit in the meaning of ‘liquidated damages’ is the idea of compensation; in that of ‘penalty,’ the idea of punishment. Thus, where the sum stipulated is reasonably intended by the parties as the predetermined measure of compensation for actual damages that might be sustained by reason of nonperformance, the stipulation is for liquidated damages; and where the stipulation is not based upon actual damages in the contemplation of the parties, but is intended to provide punishment for breach of the contract, the sum stipulated is a penalty.
Drafting Enforceable Terms:
When drafting a provision intending to stipulate liquidated damages, the drafting party should first consider whether damages are truly too difficult to calculate, which would justify the use of liquidated damages. A drafting party will often think in terms of what would happen should the other party breach the contract.
A good example of this would be renting an event space that has a contract defining rights at cancellation. Here, the drafting party may setup a structure where 90 days’ notice is a full refund, 60 days’ notice is a 75% refund, and 30 days’ notice is a 50% refund. While the details of the arrangement are necessary to determine if the setup is fair, the nonbreaching party could make the case that the difficulty in re-renting an event space justifies a sliding scale like this as it gets closer to the event date. Examples of enforceable liquidated damages provisions are nearly endless as long as it is setup as a bona fide estimate of damages rather than penalty, but you may always have some risk of creating an unenforceable penalty if you do not carefully plan out the damages provisions.