Companies—especially construction companies—often negotiate contracts that contain liquidated damages clauses. That way, both sides believe they have a fixed damage number that they can depend on without having to litigate actual damages.

But the situation is not always that straightforward. Companies can still find themselves in a fight over what the actual damages are and how that compares with the liquidated damages. One side may argue in litigation that the liquidated damage figure is so high that it constitutes an unenforceable penalty.

The Texas Supreme Court recently addressed this issue in Atrium Medical Center LP v. Houston Red C LLC, — S.W.3d —, 2020 WL 596873 (Tex. Feb. 7, 2020). The Atrium decision confirms the court’s earlier decision on when a liquidated damages provision is an unenforceable penalty. It also clarifies each side’s burden of proof when a liquidated damages clause is challenged.

The Atrium case was over a five-year specialty laundry contract between First Image laundry service and Atrium hospital. The contract contained a liquidated damages clause. The hospital encountered financial difficulties after one year and cancelled the laundry contract.

First Image sued for liquidated damages for the breach, which totaled $700,000. Atrium contended this amount far outweighed First Image’s actual damages.

The Houston Court of Appeals found for First Image and enforced the liquidated damages provision. The Texas Supreme Court agreed.

In its decision, the Texas Supreme Court confirmed the test to determine whether a liquidated damages clause is enforceable. A court will examine three issues:

1. At the time the parties entered into the contract, were the damages for breach of contract difficult or impossible to estimate?
2. At the time the parties entered into the contract, was the liquidated damages provision a reasonable forecast of the expected damages if the contract were breached?
3. At the time of the breach (not at the time the contract was entered into), were the actual damages that the plaintiff suffered significantly different than the liquidated damages?

The Atrium decision focused on the third factor.

The court reaffirmed its holding in FPL Energy, LLC v. TXU Portfolio Mgmt. Co. that a liquidated damages provision will not be enforced if there is an “unacceptable disparity” between the liquidated damages and the actual damages. In the FPL case, the court found that liquidated damages were an unenforceable penalty because the plaintiff’s actual damages were $6 million, but the liquidated damages were $29 million.

Further, the Atrium court held that it was the breaching party’s duty to prove the plaintiff’s actual contract damages and show that the liquidated damages greatly exceeded that amount.

The court then applied its legal analysis to the facts of the case.  It held that the plaintiff laundry service met its burden to prove the first two elements to enforce the liquidated damages. The plaintiff showed that the contract damages were difficult, if not impossible, to calculate at the time the contract was made because the hospital had greatly fluctuating demand for the services. Also, the liquidated damages were a reasonable estimate of the plaintiff’s lost profits from a breach, based on the company’s historical profit margin.

However, the defendant hospital failed to meet its burden of proof on the third element. The hospital did not show that there was a great disparity between the plaintiff’s actual damages for breach of contract and the liquidated damages provision. The hospital only showed the laundry service’s reliance damages for the breach, not its “lost benefit of the bargain” damages, the damages measure set forth in the parties’ contract.

Therefore, the hospital failed to prove the liquidated damages provision was an unenforceable penalty, and the court enforced the clause.

This case is significant for several practical reasons. 

First, courts will not necessarily take liquidated damages provisions at face value and summarily enforce them. Instead, if challenged, courts will carefully analyze the provision to ensure it meets the above test.

Second, each side must be prepared to meet its burden of proof. The first two elements are the plaintiff’s burden. The third element is the breaching party’s burden. That party needs to make sure it can prove the plaintiff’s actual contract damages if it wants to challenge the liquidated damages as an unenforceable penalty.

Third, business may not always welcome court scrutiny of the contract clauses that they negotiated.

But at the same time, a breaching party is assured that Texas courts will not enforce damages provisions if they require a defendant to pay far more than the plaintiff’s actual damages. This final “check” on damages may encourage businesses to enter into a liquidated damages provision in the first place.

Or, at the least, businesses should be prepared to defend the liquidated damages provision if challenged in litigation.

Schiffer Hicks Johnson is a Houston-based litigation firm with an exception trial record and a pragmatic, business-oriented approach. For more information, please contact Logan E. Johnson and Kathleen S. Rose.