California Partition Law Blog
In many contracts, the parties know that one person will be harmed if the other one breaches, but also realize that damage would be hard to calculate. So, what is a person to do to protect themselves from loss while also living their life in a way to pursue their goal? How can the law help people in that situation?
In California, liquidated damages are designed to provide compensation if a hired party fails to perform their job by setting out the specific amount of damages that will be paid if a contract is breached. Liquidated damages are not intended to punish the breaching party. Understanding the purpose and function of liquidated damages will help ensure compensation is available when damages suffered are difficult to prove.
What are Liquidated Damages?
Liquidated damages are a sum determined when a contracts is made that both parties agree will be paid if a breach of contract occurs and results in an injury or loss that is extremely difficult or infeasible to quantify. (Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal.4th 970.) Liquidated damages include a variety of actual damages and are usually included as their own clause in a contract. The sum of liquidated damages is generally of a size that effectively deters the other party from breaching the contract’s terms. If a breach does occur, liquidated damages help make the injured party whole.
California Law on Liquidated Damages
In California, the validity of liquidated damages in contracts is governed by Civil Code Section 1671. (Civ. Code § 1671.) Under Section 1671 subsection B, a liquidated damages clause is presumptively valid unless the breaching party proves the clause was unreasonable under the circumstances surrounding the contract’s creation. (Id.)
Exceptions to California’s Liquidated Damages Standard
Like many legal standards, there are several exceptions to California’s liquidated damages standard. For example, the presumption of validity standard does not apply when another statute expressly provides a rule or standard for determining the validity of a liquidated damages clause when a contract is breached. (Cal. Civ. Code § 1671(a).)
Additionally, a completely different rule applies when liquidated damages are sought from either: (1) a party to the contract who is buying or renting personal items or services for their own personal or family use; or (2) a person who is renting a residential property as a place to live for themselves and/or their dependents. (Cal. Civ. Code § 1671(c).) Liquidated damage clauses are presumptively invalid when a breach of contract occurs involving either of these types of parties. (Cal. Civ. Code § 1671(d).) In these cases, the parties to the contract may still recover compensation if they agree on an amount they presume to be equal to the damages sustained by the breach. This path to recovery is available when the nature of the breach makes it extremely difficult or impracticable to determine the sum of actual damage. (Id.)
Are Liquidated Damages Punishment for a Breach of Contract?
No. Liquidated damages are different from punitive damages because they are not intended to punish the breaching party to a contract. Liquidated damages are intended to provide parties to a contract with a degree of certainty regarding what will happen if a breach of contract occurs. Specifically, liquidated damages are intended to compensate the injured party as directly and quickly as possible after a breach.
Oppositely, punitive damages, often housed in a contract’s penalty clause, are designed to punish the breaching party for reckless, malicious, or deceitful behavior. (Cal. Civ. Code § 3294.) Punitive damages are not related to the actual losses of the injured party and are often much more expensive than liquidated damages.
Notably, California Civil Code Section 1671 prohibits punitive damages for breach of contract claims. (Cal. Civ. Code § 1671; Myers Building Industries, Ltd. v. Interface Technology, Inc. (1993) 13 Cal.App.4th 949.) This means that if the court finds liquidated damages are being used as a substitute for punitive damages the award is invalid.
How are Liquidated Damages Calculated?
Liquidated damages are calculated using different formulas depending on the contract’s nature. In real property contracts for purchase and sale truncation, liquidated damages are invalid if their sum exceeds 3% of the purchase price, unless the enforcing party establishes the exceeding sum is reasonable. (Cal. Civ. Code § 1671(b).)
In comparison, liquidated damages are calculated in construction contracts using a specific formula. (Cal. Pub. Contra. Code § 7107.) In labor cases, liquidated damage calculations consider unpaid minimum wages and unpaid overtime wages, as well as the interest on these unpaid wages. (Lab. Code §1194; Lab. Code § 218.6.)
The causes of a breach of contract resulting in payment of liquidated damages vary depending on the nature of the business relationship. Liquidated damage clauses are typically seen in contracts involving transactions like the purchasing of a home, loan repayment, trade secret disclosure, franchise agreements, or construction contracts.
When are Liquidated Damages Clauses Enforceable?
In California, courts employ a two-part test when determining the enforceability of a liquidated damages award following the breach of a real estate contract. The test considers:
- Whether the agreed upon amount of liquidated damages is reasonable in comparison to the actual damages the parties anticipated would result from a breach; and,
- Whether the parties (a) “reasonably endeavored” to estimate the sum of liquidated damages that could result from a breach, and (b) whether, at the time the contract was made, the circumstances made it “impracticable or extremely difficult” to estimate the damages that could occur. (Cal. Civ. Code § 1671.)
Courts consider a variety of additional factors when determining whether a liquidated damages provision is reasonable. These factors include:
- Whether the sum of estimated damages is reasonable.
- The circumstances at the time of the contract’s inception.
- The equality of bargaining power between parties.
- Whether each party was represented by an attorney at the contract’s inception; and,
- Whether the liquidated damages provision is part of a form contract.
A form contract is a pre-written contract full of prewritten terms that cannot be negotiated. (15 U.S.C. § 45(a)(3).) Form contracts are commonly used by parties that repeatedly enter the same type of contractual agreement. (Id.)
What is an Example?
“Shawn” is looking to buy a house in California. After months of searching, Shawn tours “Julie’s” property and makes an offer to purchase the property. Julie accepts Shawn’s offer and begins to move forward with the sale. As part of the sale process, Shawn pays Julie 2% of the house’s sale price in earnest money. Earnest money is a monetary pledge by Shawn to Julie demonstrating Shawn’s good faith intention in entering the sale to complete it. Shawn and Julie have agreed that if Shawn is unable to complete the purchase of the house, Shawn will forfeit the earnest money payment as liquidated damages. Shawn and Julie move through the sale without issue, until closing day.
On closing day. Shawn is unable to purchase Julie’s property and now must forfeit his Earnest Money payment to Julie. Requiring Shawn to forfeit the Earnest Money payment is not a punishment for failing to purchase the home. Instead, Shawn’s forfeiture allows Julie to remain whole despite the sale of her house falling through.
Conclusion
Liquidated damages are a unique remedy available in specific instances of breach of contract. The Underwood Law Firm has a team of experienced lawyers who can help resolve your real property issues as they relate to partition and help you pursue solutions to ensure your property rights are protected. We are here to help.