Penalty or damages? The enforceability of liquidated damages provisions

When one party to a contract commits a breach the innocent party may elect to sue for 'damages,' which is a fancy legal term for monetary losses. 

In some instances, the damages that have been suffered are fairly straight for­ward and easy to establish. However, in many instances, ascertaining what dam­ages have been sustained is more difficult. 

For example, if I grant you an exclusivity agreement to sell my products in a given territory and I breach that agreement by allowing someone else to sell my products within the same territory, what arc the losses that are properly attributable to my conduct? 

One could argue that your decrease in sales maybe a good indicator of your losses.

However, who is to say that market condi­tions did not happen to coincidentally also contribute to your decrease in sales? One could also argue that the sales of the other vendor may be representative of the sales that you in turn lost. Possibly, but who is to say that some of those sales occurred on account of the new vendor's efforts and therefore they were sales that you would have not been able to generate even if I had not breached our arrangement? 

These are fairly straightforward exam­ples of a problem that can in real life be­come quite complicated. 

The cannabis industry may demonstrate similar cases for a number of reasons, in­cluding the fact that the industry itself is still relatively nascent. For example, if a party breaches a contractual obligation to manufacture products for another party thereby depriving the innocent party of the revenue from the sales of those prod­ucts, how can we accurately calculate those lost revenues? If there are no mean­ingful historical sales figures, how do we know what the revenues would have been? 

While there are different ways to go about attempting to quantify those losses, often times parties will attempt to get out in front of the issue in advance and set out the damages within the contract itself. These types of clauses are known as liqui­dated damages provisions. 

Liquidated damages provisions explained

A liquidated damage provision is a clause in a contract that stipulates an amount that the breaching party must pay to the inno­cent party if a breach of the agreement oc­curs. These types of provisions can be highly useful as they allow the parties to understand precisely what the consequences will be in the event of a breach, and also to simplify the resulting legal process since the issue of attempting to determine what damages are payable is effectively eliminated. However, these clauses can also be dangerous because courts are sometimes not prepared to enforce them. 

There is a fine line between stipulating what the liquidated damages would be in the event of a breach and inserting what is effectively a penalty provision in the event of a breach. The courts have repeatedly stated that its power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. The court's power to strike down a clause has no place where there is no oppression. 
Generally, liquidated damages clauses will be enforced so long as they represent a genuine attempt to pre-estimate the loss arising from the breach. Where, however, such a clause is not based on an estimate of damages and represents a sum that is "ex­travagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach," the clause will be con­sidered an unenforceable "penalty clause:' 

The takeaway is that liquidated damages clauses are useful tools that can be inserted into commercial agreements to give the parties more certainty as to their rights and obligations in the event of a breach. This is especially useful in the cannabis industry where attempting to establish actual losses at trial can be difficult and costly. 

However, care should be taken when the clause is drafted to ensure that thought is given to the nexus between what sort of losses may be incurred and the amount provided for in the contract. 

As mentioned above, if the amount stipulated is found to be "extravagant and unconscionable" in comparison with the greatest loss that could conceivably be proved to have followed the breach, the court will not hesitate to strike down the clause and decline to enforce it.

This article was originally published in Grow Opportunity.