Liquidated damages ("LDs") allow parties to a contract, at the time of contracting, to specify an estimate of damages as a remedy for breach. LD clauses are generally structured to address specific types of breaches and for a particular breach provide for graduated damages based upon the degree of breach (e.g., by use of a formula).
In outsourcing contracts, the parties often agree to the vendor's payment of certain amounts, or agree to credit certain amounts against amounts payable by the customer, for the vendor's failure to meet certain service requirements ("Service Credits"). Service Credits are widely used and accepted in the industry as LDs in outsourcing contracts. In particular, LD clauses in such contracts typically contain an express stipulation that Service Credits constitute LDs and are the appropriate remedy for the vendor's relevant service failure.
Liquidated Damages as an Enforceable Remedy
In U.S. jurisprudence, there is a general legal right which allows a party the right to elect the remedy it may pursue for breach of contract, in addition to any express remedies (e.g., LDs) provided for in a contract. Under U.S. common law, the inclusion of an express remedy in a contract, such as an LD clause, forecloses all other remedies at law unless a contrary intention is expressed.1 Thus, in order for a party to have an enforceable right of election, the contract must contain language expressing that the LDs are optional.2
Uniform Commercial Code
In contrast to common law, the Uniform Commercial Code ("UCC") expressly stipulates that "buyers" have the right to elect the remedy they will pursue, notwithstanding the existence of any remedies provided in a contract.3 A right to elect a remedy will exist without the inclusion of any express election language, and any other contractual remedy, such as LDs, will be presumed optional unless that remedy is expressly stated as exclusive.
The UCC provides that damages for breach by either party may be liquidated in a contract, and should take into account several factors including: (1) the anticipated or actual harm caused by the breach; (2) the difficulties of proof of loss; and (3) the inconvenience or non-feasibility of otherwise obtaining an adequate remedy.4
New York Law
New York law has adopted a different approach to LDs and the right of election. Under New York law, LDs are enforceable as a remedy for breach of contract if: (1) the parties intended to liquidate damages and not to provide for a penalty;5 (2) the LD clause fixes an amount that bears a reasonable relationship to the anticipated loss suffered by the non-breaching party;6 and (3) actual loss is difficult to ascertain or incapable of estimation.7
LD clauses which have also included a right of election have been held unenforceable.8 The courts have clearly indicated that LD clauses which include a right of election, demonstrate an intent to penalize the defaulting party which negates the parties’ intention to have liquidate damages in the event of breach.9 Courts have also held that because neither party intends the specified sum to be the agreed-upon measure of damages, the provision cannot be a valid LD clause.10 As a result, if an LD clause is held to be unenforceable, the non-breaching party will only be entitled to standard, actual legal or equitable remedies for breach of contract,11 which in an outsourcing context may be difficult to determine.
Therefore, under current New York law, parties can maximize the enforceability of LD clauses by
- avoiding language that expresses a "right of elect" as an alternative remedy. Language attempting to allow a party to elect alternative remedies, in lieu of or in addition to LD damages, is unenforceable under current New York law. LDs must be expressly stated as the sole and exclusive remedy for the relevant breach;and
- specifying the amount of LDs specified, which must be reasonable and not constitute a penalty. If the amount of LDs is unreasonable, then the provision will be construed as a penalty and void under New York law.
Passing Judicial Scrutiny
Below are two typical clauses from IT services agreements:
- Vendor acknowledges and agrees that the Service Credits are a price adjustment and are not an estimate of the loss or damage that may be suffered by Customer as a result of Vendor’s failure to meet any Service Level. Payment of any Service Credit by Vendor under this Agreement is without prejudice to any entitlement Customer may have to damages at law or in equity from Vendor resulting from, or otherwise arising in respect of, any such breach of this Agreement, or to any right of Customer to terminate this Agreement.
- The parties agree that Service Credits are liquidated damages and that the payment of any Service Credit by Vendor is Customer’s exclusive monetary remedy for failure of Vendor to meet the Service Levels and is in full and final settlement of any Claim which Customer may have for Losses caused by the failure to meet a Service Level to which a Service Credit applies, provided that this Clause shall not limit the exercise by Customer of its rights to terminate the Agreement for material breach.
Which of the two clauses is enforceable under New York law? The first clause is from a standard U.S. outsourcing agreement and may not be enforceable under New York law because the customer has a right of election between Service Credits and damages. While the opening sentence attempts to get around the issue of LDs, it is unclear if a New York court would uphold such an approach.
While the second clause is more favorable to the vendor, by forcing the customer to choose Service Credits on termination for material breach, it adheres more closely to New York law. The second clause maximizes the enforceability of a LD clause under current New York law by taking into account:
- the inclusion of an express statement that Service Credits constitute LDs;
- the inclusion of an express statement that Service Credits/LDs are the exclusive remedy for a breach of Minimum Service Levels;12 and
- the absence of wording providing a "right to elect" alternative remedies.
Customers typically want to retain a right of election because it gives them greater leverage in dealing with a serious service level failure by a vendor. In fact, many customers are prepared to ignore legal uncertainties and rely on current industry practices in which many IT services contracts provide a right of election. However, for parties regularly negotiating IT services contracts under New York law, especially those representing customers, this can be an unacceptable risk. A properly drafted Service Credit provision can provide a higher
probability of enforcement under current New York law.
1. 1 BROOKSHIRE ET AL., COMMERCIAL DAMAGES: A GUIDE TO BUSINESS LITIGATION ¶ 9A.02 (Charles L. Knapp, ed., 1991); 2 ANDERSON, DAMAGES UNDER THE UNIFORM COMMERCIAL CODE § 13:11 (1994).
2. 1 BROOKSHIRE ET AL., supra, at 9.04.
3. U.C.C. § 2-719(1)(b).
4. Id. at § 2-718(1).
5. Vernitron Corp. v CF 48 Associates, 478 N.Y.S.2d 933, 934 (N.Y. App. Div. 1984); 36 N.Y. Jur. 2d, Damages § 169 (West 2003). However, in close cases, courts have tended to "favor the construction which makes the sum payable for breach of contract a penalty rather than liquidated damages, even where the parties have styled it liquidated damages rather than a penalty." Rattigan v. Commodore Int'l, Ltd., 739 F. Supp. 167, 169–70 (S.D.N.Y. 1990) (citation omitted).
6. Ames Linen Serv. v. Katz, 779 N.Y.S.2d 600, 601 (N.Y. App. Div. 2004); Time Assocs. v Blake Realty, 622 N.Y.S.2d 816, 818 (N.Y. App. Div. 1995); Vernitron Corp., 478 N.Y.S.2d at 934.
7. Vernitron Corp., 478 N.Y.S.2d at 934; 36 N.Y. Jur. 2d, Damages § 157.
8. Where an LD clause gave a plaintiff the option to disregard a liquidated sum and sue for actual damages, the clause was held to be invalid. Stock Shop v. Bozell and Jacobs, Inc., 481 N.Y.S.2d 269, 271 (N.Y. Sup. Ct. 1984). The Court reasoned that the provision was indefinite and thus unenforceable since there was no true liquidation of damages. Id.
9. A clause that established a minimum recovery with an option to seek more by way of a suit for actual damages was invalid because it was not for a fixed amount by which both parties were bound. Dalston Construction Corp. v. Wallace, 214 N.Y.S.2d 191, 193–94 (N.Y. D. Ct. 1960).
10. Option clauses are invalid penalties since they do not fix the damages in advance and are not for a certain sum. Jarro Building Industries Corp. v. Schwartz, 281 N.Y.S.2d 420, 426 (N.Y. App. Div. 1967). In Heller & Co. v. American Flyers Airline Corp., the Court implied its agreement with Jarro that LDs must be exclusive of any rights and remedies provided for by law. 459 F.2d 896, 900 (2d Cir. 1971).
11. 36 N.Y. Jur. 2d, Damages § 170; E. ALLEN FARNSWORTH, CONTRACTS § 12.18 (1990).
12. By itself, a liquidated damages clause does not exclude the enforceability of other remedies, including specific performance or injunctive relief. Rubenstein v. Rubinstein, 23 N.Y.2d 293, 297–98, 296 N.Y.S.2d 354 (1968) ("For there to be a complete bar to equitable relief there must be something more, such as explicit language in the contract that the liquidated damages provision was to be the sole remedy.").
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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