“Why Should I Have to Show Actual Damages When My Contract Has a Liquidated Damages Clause?”
When you negotiate and execute a contract with a liquidated damages clause, it’s natural to feel like you have a safety net — that in the event of a dispute you can rely on the contract to protect you from having to go through the costly and time-intensive exercise of proving your actual damages. But parties fighting an obligation to pay liquidated damages often say that the contract clause amounts to an unenforceable penalty. This argument usually involves a claim that the liquidated damages provided for in the contract far outweigh the damages actually incurred, leading to a fight over what the actual damages are. The Texas Supreme Court’s recent decision in Atrium Medical Center LP v. Houston Red C LLC, clarifies the burden of proof in these cases and shores up the value of a well-drafted liquidated damages provision.
Under Texas law, the inquiry to determine whether a liquidated damages clause is an unenforceable penalty requires three questions: (1) At the time of contracting, did the clause reasonably estimate the harm that would result from a breach; (2) Were actual damages difficult to predict when the contract was made; and (3) Whether, at the time of the breach, the liquidated damages provided in the contract exceeded the actual damages incurred?1 The first two questions require consideration of the information available at the time the contract was executed, i.e., whether the provision was an unenforceable penalty from the beginning. The last question relies on the premise that a provision not designed to be a penalty can nevertheless operate as one, based on the circumstances arising at the time of the breach.
In Justice Jane Bland’s opinion in Atrium, the Texas Supreme Court held that it was the breaching party’s burden — rather than the burden of the party seeking damages — to put forth evidence of the non-breaching party’s actual damages to “prove an unbridgeable discrepancy” between the liquidated damages provision as written and the actual damages sustained.
Atrium Medical, the owner and operator of an acute care hospital, entered into a five-year contract with ImageFirst Healthcare for specialty laundry services and to provide clean, health-care quality linens. Atrium cancelled the contract after one year and ImageFirst sued to collect liquidated damages based on the time remaining on the contract.
Atrium argued that the cancellation fee in the contract, approximately $700,000, was unreasonable because it far outweighed the damages ImageFirst incurred in reliance on the contract – the cost of linens and supplies purchased to service Atrium. The trial court ruled that the liquidated damages provision was not a penalty and that ImageFirst was entitled to its contractual profit. The 14th Court of Appeals affirmed, holding that at the time of contracting, actual damages “were very difficult, if not impossible to determine,” because the requirements contract depended on Atrium’s uncertain needs. The Court of Appeals also found that the cancellation charge was not a penalty because the evidence demonstrated it was a reasonable forecast of the harm resulting from canceling the contract.
The Texas Supreme Court affirmed. The opinion cites the court’s holding from FPL Energy, LLC v. TXU Portfolio Mgmt. Co., where it found that the “unacceptable disparity” between damages addressed under the contract (approximately $29 million) and actual damages (approximately $6 million) made the liquidated damages provision unenforceable. The court then clarified that, to avail itself of this defense, the breaching party must show an “unbridgeable discrepancy” between the liquidated and actual damages. Because Atrium only introduced evidence of ImageFirst’s reliance damages, rather than its expectation damages under the 5-year contract, Atrium had failed to meet its burden to show such an “unbridgeable discrepancy.”
The holding in Atrium Medical provides some assurance of the freedom to contract for liquidated damages and that Texas courts will uphold reasonable contractual damages provisions. This outcome, however, does not mean that, when your contractual counterparty breaches and you have a liquidated damages contract provision, you have a fast pass to judgment. The breaching party could still argue that the liquidated damages provision was unenforceable from the outset, as an unreasonable forecast of the harm. The breaching party could also try to use discovery to uncover what the actual damages were in order to meet its burden of proof. And as FPL Energy and Atrium Medical illustrate, if there is an “unbridgeable discrepancy” between the contract provision and the actual damages, the liquidated damages will be found to be unenforceable as a penalty.
1 Atrium Medical Ctr., LP v. Houston Red C LLC, — S.W.3d –, 2020 WL 596873, at *1 (Tex. Feb. 7, 2020) (citing Phillips v. Phillips, 820 S.W.2d 785, 788 (Tex. 1991) and FPL Energy, LLC v. TXU Portfolio Mgmt. Co., 426 S.W.3d 59, 69 (Tex. 2014)).
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.