Liquidated damages vs. penalty: two-gate test
Remedies & Third Parties · Apr 14
Floor. ~40 min: R2d § 352 + Lake River. The doctrine the next class assumes you have covered.
Target. ~75 min: Floor + R2d § 356 + synthesis.
Damages are not recoverable for loss beyond an amount that the evidence permits to be established with reasonable certainty.
R2d § 352 bars damages "beyond an amount that the evidence permits to be established with reasonable certainty." This is the plaintiff's proof problem, distinct from foreseeability (the defendant's knowledge problem).
Two moves the rule turns on:
(1) Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.
(2) A term in a bond providing for an amount of money as a penalty for non-occurrence of the condition of the bond is unenforceable on grounds of public policy to the extent that the amount exceeds the loss caused by such non-occurrence.
A liquidated-damages clause is enforceable only if it passes both prongs (R2d § 356 / UCC § 2-718):
(1) Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty.
(2) Where the seller justifiably withholds delivery of goods because of the buyer’s breach, the buyer is entitled to restitution of any amount by which the sum of his payments exceeds
(a) the amount to which the seller is entitled by virtue of terms liquidating the seller’s damages in accordance with subsection (1), or
(b) in the absence of such terms, twenty per cent of the value of the total performance for which the buyer is obligated under the contract or $500, whichever is smaller.
(3) The buyer’s right to restitution under subsection (2) is subject to offset to the extent that the seller establishes
(a) a right to recover damages under the provisions of this Article other than subsection (1), and
(b) the amount or value of any benefits received by the buyer directly or indirectly by reason of the contract.
(4) Where a seller has received payment in goods their reasonable value or the proceeds of their resale shall be treated as payments for the purposes of subsection (2); but if the seller has notice of the buyer’s breach before reselling goods received in part performance, his resale is subject to the conditions laid down in this Article on resale by an aggrieved seller (Section 2-706).
769 F.2d 1284 (7th Cir. 1985)
U.S. Court of Appeals for the Seventh Circuit
Rule. A liquidated-damages clause is enforceable only if the harm to be caused by the breach was difficult to estimate at the time of contracting and the amount fixed is a reasonable forecast of just compensation. A clause that operates as a penalty (designed to deter breach rather than compensate the non-breaching party) is unenforceable, even between sophisticated commercial parties.
8 Ill. 2d 351 (1956)
Supreme Court of Illinois
Rule. A clause that withholds payment on breach is tested for whether it is a reasonable forecast of damages or an unenforceable penalty. A forfeiture clause that is in fact a penalty does not bar other relief, and even a genuine liquidated-damages clause does not foreclose injunctive relief unless the parties clearly made damages the sole remedy.
Facts. CrowdStrike contracts with Delta to defend against hacks for $1M/year. Contract caps liability at the contract price. CrowdStrike's defective update grounds Delta's fleet. Delta loses $10M in revenue + $2M in FAA penalties. Delta sues for $12M, arguing the cap is unconscionable.
Question. Is the cap enforceable?
Analysis. UCC § 2-719(3) (cap analogue to § 2-718): consequential-damages limits enforceable unless unconscionable. Sophisticated parties + arm's length + industry custom + alternative risk allocation (Delta could have bought insurance) all support enforcement.
Against: 12:1 ratio between cap and loss; failure of essential purpose if the cap defeats the contract's protection function.
Likely result. Cap enforced on the revenue loss. FAA penalties may fall outside the cap if they qualify as direct rather than consequential; the contract language matters.
Variation — airplane crash. Public-safety overlay: courts decline to enforce caps that shield catastrophic personal-injury liability.
UCC § 2-719(2). If a limited remedy "fails of its essential purpose," the buyer may pursue any other remedy under the UCC despite the cap.
Apply to CrowdStrike: if the contract gives Delta only a refund of the contract price as remedy, and CrowdStrike's failure cost Delta $12M, the refund is arguably no remedy at all. The cap fails of its essential purpose, opening Delta to full consequential damages, unless the contract separately excludes consequentials (most do).
The doctrine has its critics; courts split on whether "failure of essential purpose" extends to consequential-damages exclusions or only to repair-or-replace clauses.
Facts. Zoe contracts $50,000 of organic seeds; consequential damages capped at $25,000. Harvest Supply delivers non-organic. Zoe loses organic certification and a $200,000 government subsidy.
Question. Is the cap enforceable? Recoverable?
Answer. Four-filter analysis: (1) foreseeability — depends on whether Zoe communicated the subsidy contingency; (2) certainty — was the subsidy guaranteed?; (3) mitigation — could Zoe have planted replacement seeds?; (4) the cap itself — enforceable absent unconscionability, but failure of essential purpose available if cap defeats remedy.
Realistic outcome: cap likely enforced; recovery limited to $25,000 plus the direct loss on the seeds.
Rules. R2d § 352 (certainty), § 356 (liquidated damages); UCC §§ 2-718, 2-719.
Cases. Lake River v. Carborundum (Posner, penalty doctrine applied to sophisticated parties).
Punchline. Parties may agree to a damages number — but the number must pass both gates of the reasonableness test. The doctrine constrains private ordering even between sophisticated commercial parties.
Open question. When money cannot do the work, what then? Next class: specific performance, restitution, and the equitable substitutes.
Next class: Alternative Remedies — Specific Performance + Restitution
_Remedies & Third Parties_ · Apr 15
Read R2d §§ 359, 360, 367 (specific performance) and §§ 370, 373 (restitution). If a seller breaches a contract to convey a unique painting, why is the painting itself the remedy and not money? When does the law abandon the money default and reach for the thing? Come ready to answer. You may be called.