Opinion ID: 2592878
Heading Depth: 1
Heading Rank: 4

Heading: Is the liquidated damages clause really a penalty?

Text: Next, Carrothers argues the liquidated damages clause is unreasonable and constitutes a penalty because the contractually specified damages bear no reasonable relationship to the actual injury suffered by the City after it occupied the new plant and switched over its municipal services from the old plant. Carrothers' argument focuses entirely on the time period after, it claims, the City obtained beneficial use from the new facility in November 2003. Carrothers contends Kansas law imposes a two hurdle test for enforceability of a liquidated damages provision. Such a provision is invalid, Carrothers asserts, unless it is both: (1) a reasonable prospective estimate of damages for the breach of contract; and (2) reasonable considering, retrospectively, the damages actually incurred. Carrothers argues that once the City started using the new wastewater treatment plant, the contractually stated liquidated damages necessarily became a penalty under the second prong of its proposed test because the City was suffering no actual harm after this transition. We disagree and hold the retrospective analysis is unnecessary in determining whether a liquidated damages clause is a penalty. The better test, we believe, is to determine the reasonableness of a liquidated damages clause as of the time the contract was executed, not with the benefit of hindsight. As noted previously by this court, a liquidated damages clause in a contract is an advance settlement of the anticipated actual damages arising from a future breach. St. Louis & S.F. Railroad Co. v. Gaba, 78 Kan. 432, 435-436, 97 Pac. 435 (1908). Such provisions allow contracting parties to protect themselves against the difficulty, uncertainty, and expenses that necessarily follow judicial proceedings when trying to ascertain actual damages. Oriental Gardens, 32 Kan.App.2d at 563, 86 P.3d 543. Given this desirable goal, it is well established that parties may stipulate at the time of contracting to a set damages amount for a breach of that contract, as long as the liquidated damages provision is not a penalty. See White Lakes Shopping Center, Inc. v. Jefferson Standard Life Ins. Co., 208 Kan. 121, 126-128, 490 P.2d 609 (1971); Beck v. Megli, 153 Kan. 721, 726, 114 P.2d 305 (1941); Gregory v. Nelson, 147 Kan. 682, Syl., 78 P.2d 889 (1938); Gaba, 78 Kan. at 435-36, 97 P. 435. The distinction between a contractual penalty and a provision for liquidated damages is that a penalty, in effect, is a security for performance, while a provision for liquidated damages requires a sum certain to be paid in lieu of performance. Erickson v. O'Leary, 127 Kan. 12, 14, 273 P. 414 (1929). In considering the issue, this court previously stated: In determining whether contractual agreements are to be treated as penalties or as liquidated damages, courts look behind the words used by the contracting parties to the facts and the nature of the transaction. The use of the terms `penalty' or `liquidated damages' in the instrument is of evidentiary value only. It is given weight and is ordinarily accepted as controlling unless the facts and circumstances impel a contrary holding. [Citations omitted.] The instrument must be considered as a whole, and the situation of the parties, the nature of the subject matter and the circumstances surrounding its execution taken into account. There are two considerations which are given special weight in support of a holding that a contractual provision is for liquidated damages rather than a penaltythe first is that the amount stipulated is conscionable, that it is reasonable in view of the value of the subject matter of the contract and of the probable or presumptive loss in case of breach; and the second is that the nature of the transaction is such that the amount of actual damages resulting from default would not be easily and readily determinable. [Citations omitted.] Beck, 153 Kan. at 726, 114 P.2d 305. In TMG Life Ins. Co. v. Ashner, 21 Kan.App.2d 234, 250, 898 P.2d 1145 (1995), the Court of Appeals ruled the burden of proving a liquidated damages clause is an unenforceable penalty falls on the party challenging the provision. See Oriental Gardens, 32 Kan.App.2d at 561, 86 P.3d 543. We agree. By placing the burden of proof on the party challenging a liquidated damages clause, we promote a public policy favoring settlement and avoidance of litigation, and allowing parties to make, and live by, their own contracts. See White Lakes Shopping Center, 208 Kan. at 126-28, 490 P.2d 609; Anderson v. Rexroad, 180 Kan. 505, 511-15, 306 P.2d 137 (1957). In addressing these two considerations (reasonableness and difficulty of ascertaining actual damages), the Court of Appeals noted the first factor was resolved in the City's favor as follows: Here, the subject matter of the contract was the construction of a new public wastewater treatment facility for over $5,600,000. As the City points out, the total liquidated damages of $145,350 for a nearly 6-month delay is less than 3% of the total contract amount. The probable or presumptive loss in case of delay included the City's cost to monitor the project, additional labor costs, additional use of utilities, the cost of engaging another consultant, legal expenses, equipment rental to address flow situations, possible action by the KDHE, and other unknowns in the event the project was not completed on time. MKEC anticipated having an engineer's representative on site daily if the facility was not completed on time, as well as additional environmental department staff, structural and electrical staff, and controls department staff. In light of these potential actual expenses, the amount set forth in the contract of $850 per day is reasonable when viewed prospectively. Carrothers, 39 Kan.App.2d at 713, 184 P.3d 943. As to the second consideration, the Court of Appeals stated the following in deciding the amount of actual damages from a default would not be easily and readily determinable: Here, Moore stated in his deposition that MKEC always includes a liquidated damages clause in its public works contracts because it is difficult to determine what damages would be incurred and it could be costly to prove those damages in court. The district court noted the complexity of the project and its attendant risks of harm and damages. As demonstrated by the many factors MKEC considered in determining the appropriate amount of liquidated damages, the actual damages would have been difficult to calculate at the time the parties entered into the contract. Therefore, this second factor also favors enforceability of the liquidated damages provision. 39 Kan.App.2d at 714, 184 P.3d 943. We agree with the Court of Appeals' analysis as to these two considerations. It is clear from the facts the project engineer attempted as a part of the contract drafting process to calculate estimated damages if there were a breach. It also is clear a project with this level of complexity would present significant difficulties in trying to calculate actual damages. Under these circumstances, the parties legitimately could agree in the interests of necessity, economy, and convenience to set the damages level in advance, which is what they did. We would supplement these points only by emphasizing that we are dealing here with a contract for the construction of public utility service facilities. It is uniquely difficult to calculate damages to the general public interest caused by a contractor's breach of its agreement to provide public improvements. This should be an important consideration in such cases and weigh favorably in finding a liquidated damages provision to be reasonable. Kansas has long recognized the protection of the public interest is a proper consideration in determining validity of a liquidated damages provision. Kansas City v. Industrial Gas Co., 138 Kan. 755, 762-63, 28 P.2d 968 (1934); U.S.D. No. 315 v. DeWerff, 6 Kan.App.2d 77, Syl. ¶ 3, 626 P.2d 1206 (1981). But Carrothers promotes an additional retrospective analysis by which to judge the reasonableness of this liquidated damages provision. Under this approach, Carrothers argues, a court must determine what actual damages resulted from its failure to achieve the required completion dates, and then compare those actual damages to the liquidated damages calculations set out in the contract. We note that courts are divided in the approaches employed to determine this issue. See Kelly v. Marx, 44 Mass.App.Ct. 825, 694 N.E.2d 869, 873-74 (1998), surveying state by state the applicable liquidated damages rules in place at that time. In support of its position, Carrothers claims the Tenth Circuit Court of Appeals recently found Kansas law applies this additional retrospective test, citing Hutton Contracting Co. v. City of Coffeyville, 487 F.3d 772 (10th Cir.2007). Carrothers is wrong in making this claim. The Hutton court expressly did not adopt the retrospective test. Instead, the court indicated Kansas courts have not definitely answered the question whether enforceability of a liquidated damages provision should be determined prospectively only or whether Kansas courts would also apply a retrospective analysis. 487 F.3d at 781 ([O]ur review of Kansas cases finds no definitive discussion of whether Kansas courts would apply a supplemental retrospective analysis.). To that end, our decision in this case is intended to lay aside any further doubt and embrace a prospective analysis as the sole basis for evaluating a liquidated damages provision in a contract. To the extent any prior decisions of our Court of Appeals have contributed to that doubt by adding a retrospective test in their determination of this issue, they are overruled as to this limited point. See Carrothers, 39 Kan.App.2d at 712-13, 184 P.3d 943; Oriental Gardens, 32 Kan.App.2d at 564, 86 P.3d 543; Luminous Neon, 17 Kan.App.2d at 243, 836 P.2d 1201. The prospective approach is particularly appropriate in circumstances such as those presented here, when an evaluation was made prior to contract formation as to the probable loss resulting from delay, the parties' clear intent to use liquidated damages as the contractual vehicle in case of a delay because actual damages would be difficult to ascertain, and the parties' agreement as to a per diem amount for delays, which then set the parties' respective risks. To impose the two hurdle test advocated by Carrothers would deny the parties' obvious intent and deny the City the benefit of its bargain. If the amount of actual damages is made an issue in the enforcement of every contract with a liquidated damages provision, the very purpose of the agreement is undermined. As noted in the Restatement (Second) of Contracts § 356, comment A, p. 157 (1979): The enforcement of such provisions for liquidated damages saves the time of courts, juries, parties and witnesses and reduces the expense of litigation. Here, the parties intended to avoid such expense and uncertainty if a delay occurred. Their intent should be respected. We affirm the findings by the Court of Appeals and district court that the liquidated damages clause did not constitute a penalty.