Go With the Flow: Creating Enforceable Liquidated Damages Clauses in Real Estate Contracts

December 4, 2015

A provision commonly utilized in commercial real estate contracts is a liquidated damages clause. This clause is utilized as an incentive so all parties involved in the transaction perform as stipulated under the contract. If they fail to do so, the harmed party can pursue restitution through the liquidated damages clause.

You must be careful when drafting the language of the clause because in California a liquidated damages provision is presumed to be enforceable, but could be voided if it is viewed as a penalty by a court.

In the 1970s, California adopted a policy of presumptive validity for liquidated damages clauses in commercial contracts, including real estate contracts. This means that a clause in a contract liquidating damages for a breach is valid unless the party challenging the provision can show that the provision was unreasonable under the circumstances when the contract was formed, or is so draconian that it is essentially a penalty.

Properly drafting a liquidated damages provision requires precision (why you should retain a Sacramento real estate attorney to help you in drafting your contract). An unreasonable provision can completely negate the liquidated damages clause. For example, the 1997 case Ridgley v. Topa Thrift & Loan Association, involved a contract dispute between a lender and borrower over a provision allowing the lender to charge a fee equal to six months' interest if the borrower made a late payment on the loan. The court in the case considered whether the provision was a valid charge for a prepayment of the loan principal or an unenforceable penalty for delinquency in a monthly interest payment. The court ultimately decided that the six month interest charge imposed for any late payment was not a reasonable attempt to anticipate damages from default and voided the provision.

The take-away: a court analyzes liquidated damages provisions based upon their impact on the parties.

The amount set as a liquidated damage needs to represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained by a breach of contract, according to an article published on Mondaq.com.

Along with a liquidated damages clause being reasonable, the provision in a property contract and sale agreements concerning the buyer's default must be signed or initialed by each party to the contract.

If you have a printed, hard copy contract, the liquidated damages clause must be at least 10-point bold type or in contrasting red print in at least eight-point bold type. Yes, the courts are that specific. The reason is that they do not want a liquidated damages clause to be hidden in the fine print and surprise one of the parties.

As you can see, properly drafting a liquidated damages clause is extremely important. These provisions are presumed valid, but can be voided by a court if they are determined to be unreasonable and/or unduly harsh. This is why you need an experienced real estate attorney to help in the drafting process. Kristina Reed is here to help. Contact her today to discuss your contractual needs.