Liquidated Damages: Too High and It’s a Penalty. Too Low and You’re Out of Luck.
Liquidated damages provisions in commercial and residential real estate contracts play a vital role when a transaction goes south, and should be given careful consideration when negotiating a real estate contract. Liquidated damages may be referred to in a variety of ways, such as “earnest money,” a “good-faith deposit,” or a “non-refundable deposit,” but each typically denote a negotiated amount of money that a seller is entitled to retain should a buyer breach a purchase and sale agreement. The purpose of liquidated damages is to provide the parties with certainty when actual damages arising from a breach of contract may be difficult to calculate. Accordingly, liquidated damages provisions alleviate the need for potentially expensive litigation associated with proving damages.
While parties are free to negotiate the amount of liquidated damages, the amount must approximate the loss anticipated at the time of contracting, or the loss that actually occurs as a result of a breach. Arizona courts have held that where the amount of liquidated damages is unreasonably large when compared to the anticipated loss or actual loss, the liquidated damages provision is unenforceable as a penalty. A breaching party faced with high liquidated damages will often seek to invalidate the provision as a penalty. If a court agrees, the non-breaching party may still recover damages, but must go through the process of proving such damages. Therefore, when negotiating a real estate contract, consideration should be given as to whether a liquidated damages amount is arbitrarily high when compared to an anticipated loss in the event of a breach.
In contrast, setting the amount of liquidated damages too low may have the undesirable consequences of preventing a non-breaching party from recovering the actual and full amount of damages that the party suffered. For example, this may occur when the real estate market experiences a rapid downward trend during escrow such that a seller can no longer sell the property for nearly as much after the breach as before going under contract. However, in Roscoe-Gill v. Newman, 188 Ariz. 483 (Ct. App. 1996), the court held that the principles that justify invalidating a liquidated damages provision for being an unreasonably large penalty do not support invalidating a liquidated damages provision that is claimed to be insufficient. Rather, unless the non-breaching party can establish fraud, duress, or unconscionability, a liquidated damages provision will be enforced despite the liquidated damages amount being inadequate to compensate the non-breaching party for damages actually incurred. Therefore, care should be taken when determining what anticipated damages may be incurred that are covered by a liquidated damages provision.
Factors that a party may consider when determining a liquidated damages amount include:
- The time, difficulty, and cost associated with finding another buyer.
- The cost of carrying the property until another buyer is identified.
- Whether the real estate market is trending up or down.
- Consequential damages, meaning damages that arise indirectly from the breach, such as the loss of use of the funds that would have been received.