Anglo-American contract law usually respects the terms of contracts — but not always. One potential trap for the unwary is that contractual “penalties” are generally unenforceable. This has given rise to the concept of “liquidated damages,” an agreed formulation for the damages that the parties expect to incur in the event of a breach.
Liquidated Damages under U.S. State Law
Under New York law, one of the most popular governing laws for high-value contracts, liquidated damages have been found to be unenforceable in a number of cases.
The overarching theme of these cases is that New York courts do not favor liquidated damages that are not proportional to actual losses. For example, a fixed amount of liquidated damages for a breach of a lease agreement may fall afoul of this rule, since the timing and nature of the breach will have significant impacts on the losses sustained by the other party. Liquidated damages imposed in addition to actual damages will also be subject to challenge.
Liquidated damages are therefore most suitable for contracts where the actual loss is difficult to predict or prove, but can be estimated and calculated by a reasonable formula. For example, liquidated damages for non-delivery of goods should typically consider the quantity of goods and the difference between the contract price and the market price of the goods (each party’s “cost of cover”), and may also need to factor in the length of the delay in delivery.
Liquidated Damages under the UCC
Contracts for the sale or lease of goods that are governed by U.S. state law are subject to the Uniform Commercial Code (UCC). Section 2-718(1) of the UCC allows liquidated damages in sales contracts “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.” It also provides that “a term fixing unreasonably large liquidated damages is void as a penalty.” Section 2A-504 provides a parallel rule for lease contracts, allowing liquidated damages “only at an amount or by a formula that is reasonable in light of the then anticipated harm caused by the default or other act or omission.”
Penalties in Other Countries
Most countries in the English-speaking world have inherited contract law from English common law, and have inherited its limitations on contractual penalties. However, these vary from country to country. For most of the 20th century, English law required liquidated damages to be a “genuine pre-estimate” of actual losses. The English Supreme Court narrowed the scope of this rule in 2015 so that, at least in contracts between equal sophisticated parties, liquidated damages clauses are generally upheld, as long as they are not “extravagant” or “unconscionable.” This approach has since been rejected in other common law jurisdictions such as Singapore and Hong Kong, both of which continue to follow the previous English rule.
Many countries outside the English-speaking world do not have similar restrictions on contractual penalties: for example, in Japanese law contracts, it is very common to have penalties (違約金 iyakukin) that apply as fixed or minimum liability amounts in the event of any breach, often between 20 and 50 percent of the contract value. These penalties are generally upheld, except to the extent they are abusive or violate public policy.
This distinction between legal systems is one reason why governing law clauses can have a major impact on the effectiveness of a contract.