Opinion ID: 886354
Heading Depth: 3
Heading Rank: 2

Heading: Judicial Enforcement of Liquidated Damages

Text: ¶ 23 Because judicially rewriting a contract is foreign to the principle of freedom of contract and to the court's normal role of interpretation and enforcement of expectancy damages, the law of liquidated damages has a somewhat tortured history. Indeed, the disparity in Montana's case law is apparently only one of numerous examples, as the commentators on the subject note many inconsistencies. See Kenneth W. Clarkson et al., Liquidated Damages v. Penalties: Sense or Nonsense?, 1978 WIS. L.REV. 351 (hereinafter Clarkson) (The ablest judges have declared that they felt themselves embarrassed in ascertaining the principle on which the decisions [distinguishing liquidated damages from penalties] ... were founded. quoting Ruggles, J. in Cotheal v. Talmage (1854), 9 N.Y. 551); Goetz, 554 & n. 2. ¶ 24 In order to determine whether a clause should be declared a penalty, courts attempt to measure the reasonableness of a liquidated damages clause. Because the language of the clause is obviously not controlling, courts look beyond the contract to analyze reasonableness. As indicated by Montana's statute on liquidated damages, § 28-2-721, MCA, [6] and by treatises including WILLISTON ON CONTRACTS, § 65:1, and § 356 of the RESTATEMENT (SECOND) OF CONTRACTS (1965) (hereinafter RESTATEMENT § 356), the threshold indicator of reasonableness is whether the situation involves damages of a type that are impractical or extremely difficult to prove. When the parties to the contract will suffer difficult to prove damages, a court can assume there was a reasonable motive for adding a liquidated damages clause, because, as mentioned, stipulated damages can quantify damages that a court could not otherwise award for lack of proof. [7] However, because the difficulty of proof of damages does not by itself demonstrate reasonableness, courts must look further to the amount of damages. ¶ 25 According to RESTATEMENT § 356 and other treatises, damages must be reasonable in relation to the damages the parties anticipated when the contract was executed or in relation to actual damages resulting from the breach. However, these tests are of limited value for a number of reasons. First, the reasonableness of anticipated damages can be difficult to determine because, as mentioned, the parties are usually in a situation where damages are difficult to prove. Hence, the question of reasonableness becomes somewhat circular and subjective: how can one meet a burden of proof to demonstrate anticipated damages are reasonable and yet difficult and impractical to prove at the same time? While this proof may be theoretically possible, it inevitably provides fertile grounds for disagreement between the parties. ¶ 26 Second, regarding the relation between actual damages and stipulated damages, the parties are usually already before the court because one party asserts the disparity is too great in the first place. The breaching party often argues the stipulated damages should not be enforced because the nonbreaching party did not suffer any actual damages. See, e.g., O'Keefe v. Dyer (1898), 20 Mont. 477, 484-85, 52 P. 196, 199 (clause a penalty in part because no actual damages suffered). Consequently, this rule provides courts little guidance because a comparison of actual to stipulated damages is conclusory and ignores difficult to prove damages. Finally, because the language of RESTATEMENT § 356 uses or to indicate either anticipated or actual damages can be used to determine reasonableness, parties argue over which of the tests should apply to their case. For instance, if a clause was reasonable at the time of contracting but unreasonable after the fact, must it be upheld by a court as enforceable or struck as a penalty? See Larry A. DiMatteo, A Theory of Efficient Penalty: Eliminating the Law of Liquidated Damages, 38 Am. Bus. L.J. 633, 724 (2000-01) (hereinafter DiMatteo) (noting proposed liquidated damages reforms to the Uniform Commercial Code Article 2 that allow either test to satisfy reasonableness). ¶ 27 As a result of this lack of clarity, courts often inquire into the intent of the parties at the time of contracting in order to determine reasonableness. See WILLISTON ON CONTRACTS, § 65:11. Specifically, courts look to whether the parties negotiated the clause at issue and whether the parties actually attempted to estimate damages in order to determine if the bargaining process was voluntary. However, there is often a lack of evidence of specific negotiation on the liquidated damages clause. Further, form contracts with predrafted liquidated damages present a special problem under this test because there is always a lack of evidence of negotiation. Courts cannot simply strike all stipulated damages clauses in form contracts based on lack of negotiation because such contracts are widely used, the terms are often reasonable, and the contracts provide efficiencies necessary to the conduct of everyday business. Consequently, the intent test has limited usefulness as well. ¶ 28 When there is evidence of intent, courts look to whether one of the parties specifically intended to penalize the other party for breach in order to secure their performance rather than simply provide for an amount designed to properly compensate for the failure to perform. Under this rule, penalty clauses are declared in terrorem for unfairly forcing performance. See Goetz, 555. However, as WILLISTON ON CONTRACTS points out, [D]amages for breach of contract, by their nature, induce performance of contractual undertakings.... [M]erely because a liquidated damages provision induces performance of a contract does not make the clause a penalty; it is only when it induces performance illegitimately, as when the amount is disproportionately large relative to the reasonably anticipated probable damages (or in some jurisdictions, relative to the actual damages suffered) so that performance is coerced by making breach unreasonably costly. WILLISTON ON CONTRACTS, § 65:1. Therefore, because parties usually prefer performance of a contract over payment of damages, courts cannot simply strike as in terrorem the legitimate use of liquidated damages to induce performance when evidence demonstrates one party intended to secure performance. Rather, other evidence of unreasonableness, such as that discussed above, is needed to show a clause is a penalty. ¶ 29 Personal service contracts are a particularly good example of the shortcomings of declaring a clause in terrorem based only on intent. Liquidated damages in a personal service contract induce performance by an employee by predetermining compensation to an employer if the employee leaves. However, the employer clearly prefers performance by the specific employee because that employee was chosen for hire. The preference for performance by a specific person is reflected in the rule that personal service contracts are not assignable. Further, because personal service contracts are not enforceable by specific performance, Reier Broad. Co. v. Kramer, 2003 MT 165, ¶ ¶ 11, 16, 316 Mont. 301, ¶ ¶ 11, 16, 72 P.3d 944, ¶ ¶ 11, 16, liquidated damages are an appropriate way for employers to protect their interests. See United States v. Martin (C.D.Cal.1989), 710 F.Supp. 271, 275 (liquidated damages in personal service contract is not involuntary servitude but monetary compensation for contract damages). Therefore, declaring such a clause in terrorem can remove an employer's legitimate efforts to secure performance by a specific employee. ¶ 30 Finally, courts also look to how the clause operates as an indicator of reasonableness. For example, courts look at whether the clause provides for the same damages without regard to the materiality of the breach or whether the clause penalizes a mere delay in payment. Wibaux v. Grinnell Live-Stock Co. (1889), 9 Mont. 154, 164-66, 22 P. 492, 495 (no provision for partial breach converts liquidated damages to a penalty); Comphealth, Inc. v. Highland View Outpatient Surgical Ctr. (1989), 240 Mont. 366, 369, 783 P.2d 1385, 1388 (substantial rather than full compliance with cancellation provisions sufficient to prevent award of liquidated damages). Again, however, these tests have failings as well in that reasonable clauses can be declared penalties. See DiMatteo, 657-706 (discussing the inefficient results under the various tests). ¶ 31 The end result of these rule variations is that a clause may be reasonable under one test, but unreasonable under another. Consequently, oftentimes, as in the case at bar, the parties disagree about what tests apply to the contract at issue. In addition, parties dispute who has the burden of proof and even whether the question is one of fact or law. To add to the lack of direction, courts tend to only discuss the test under which the clause in that case is held to be a penalty, rather than assessing the clause under each perspective. In sum, these various tests and others result in inconsistencies in the law of liquidated damages and Montana's jurisprudence is no exception. To illustrate, we now turn to Montana's case law on the subject.