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LIQUIDATED DAMAGES - WHAT ARE THEY?

Mar 20, 2014
Article #242
Author: Mel Jones

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Always seek professional and licensed legal advise from an attorney before relying on the information pcontained in this article. Each state has different laws and each situation has different fact patterns requiring different legal advise. The purpose of this article is to give you some education into the liquidated damages clauses.

LIQUIDATED DAMAGES

Liquidated damages language are inserted into contracts to limit the liability of the party creating the harm or breaching the contract.  For example, Party A breaches the contract with Party B.  If there is a liquidated damages clause in the contract, then Party B has the rights to exercise the clause and take the money specified in the clause, which is usually the earnest money deposit. But hold your horses, it's never that easy. 

Liquidated damages clauses are a great way to reduce litigation risk but if the liquidated damages clause goes too far, in other words the amount involved becomes a penalty rather than a good estimate of the damages, then the clause could become unenforceable and invalid and you'll find yourself hold the proverbial wet paper bag. Each state has different rules, but I want to educate you on the concepts determining a good liquidated damages clause.

In theory, the liquidated damages clause must bare some semblance of reality. In our business it isn't clear what real damages have been done in the event a buyer breaches the contract or a seller for that fact. What damages has a seller suffered? Sometimes it could be lost business, lost employees or even lost customers. To attempt to qualify this is a challenge.

But a liquidated damages clause could be riding in a grey area of becoming invalid if it turns into a penalty. Often a seller wants to jump on a liquidated damages clause to take the earnest money when a buyer gets cold feet.  But the purpose of the clause is to compensate the party harmed by the breach. Can a seller really make a case he or she was harmed because of the buyer's breach. Not likely unless the buyer has gone into the business and messed things up, which I have seen happen several times. 

ACTUAL CASE EXAMPLE
I recently had such a case. This buyer, an attorney, took it upon himself to take complete control of the purchasing process despite my warnings not to…you know attorneys, smarter than all human being is what they think and brokers are stupid too! Our standard purchase agreement wasn't good enough for him, so he massively modified it…and he later wished he hadn't…There was no stopping him. He hired a PR firm, contractors, consultants and even hired a general manager and executive chef before due diligence was completed let alone before the deal was closed.  He insisted on talking to employees, managers and customers.   He insisted on doing it all his way.  So about four months into this mess, the restaurant's financial performance faltered. Numbers were dropping fast. Why they were, who really knows, but that's not the point. 

The point is the deal was falling apart faster then Elmers Glue in Scottsdale AZ in August. Well a pissing match started! The smell of a law suit was lurking. The buyer was screaming fraud. The seller was screaming damages in the hundreds of thousands blaming the buyer for the messed-up business.  About a month into the screaming matches the buyer calls me saying "damn, why didn't I sign the liquidated damages clause!"  Of course I wanted to say "because you're an arrogant buffoon!" But I didn't!

Had he signed the liquidated damages clause, his lost could have been limited to the deposit in escrow, in theory of course. The seller would have to prove that the amount in escrow was grossly insufficient to satisfy the damages.  At that moment in time he would have gladly gone down that road and walked from the deposit and not spent another $25,000 on attorney fees fighting the seller. 

COURT CASES
Let's take some cases.  In one instance, a federal district court upheld a liquidated damages clause that forced a buyer to forfeit a deposit for the purchase of a vintage car. The buyer had failed to pay the balance due, and the dealer sold the car to someone else for more money. The buyer sued for return of his deposit, but the court, after analyzing several factors, upheld the liquidated damages clause stating "the amount of damages actually suffered has no bearing on the validity of the liquidated damages provision." and noted that the amount in question was a standard figure in vintage-car sales contracts - a key fact that supported a finding of reasonableness. We'd be hard press to determine a standard figure in our business.

This court also cited other factors, such as "the relative equality of the bargaining power of the parties" and whether lawyers represented the parties when the contract was made. A crucial fact was that the buyer was sophisticated in the practices of buying and selling high-end vintage cars. In the overall context, the court observed that the amount of liquidated damages reasonably reflected the defendant's risk, as well as the damages that could have been anticipated at the time of contracting.

However, in a different situation - involving real estate - the sophistication of the parties proved to be irrelevant. A California appellate court held unenforceable a nonrefundable-deposit provision in a $14 million residential purchase contract. Both parties were deemed sophisticated, and the buyer backed out while the seller proceeded to sell the property for more money to a third party. But the result was far different from the vintage-car case.

In fact, the nonrefundable-deposit provision did not even appear to comply with Civil Code section 1675, which covers liquidated damages clauses in residential real estate purchase contracts. Interestingly, the Kuish court did not base its decision on section 1675. Rather, it noted in a rising real estate market, where the property resells for more than the original purchase price, the seller has not sustained a damages. In that scenario, a nonrefundable deposit would constitute an unenforceable penalty.

So perhaps if you're buying a business and default and the seller turns around and sells it for a higher price, then the likelihood of having liquaidated damages is nil.

COMMERCIAL CONTRACTS
The rules are different in the commercial context. Pursuant to the code, a liquidated damages clause in a nonresidential real estate purchase contract is presumed valid if the provision is separately signed or initialed by each party and, if contained in a printed contract, it is set out in at least 10-point bold type or in contrasting red print in at least 8-point bold type. Even so, if the party seeking to invalidate the clause establishes that the provision was unreasonable under circumstances existing at the time the contract was made, a court can still strike it down.

One should note that the statutes dealing with liquidated damages in real estate purchase contracts do not affect a party's right to obtain specific performance of the contract terms. 

 

                                                                                                                                                                                                                                                       

We at SellingRestaurants feel obligated to educate the public, our customers and our clients with information that can help them make more intelligent buying and selling decisions. 

Mel Jones is one of the premier restaurant brokers in the nation having published hundreds of articles on buying and selling a restaurant and bar business, selling thousands of restaurants in CA., WA and AZ and building one of the most copied business models in the brokerage industry.  Mel started SellingRestaurants in 2004 with the one simple concept, give the buyers the information they need to make intelligent buying decisions without being pestered by a broker or hiding information, prepare the business for market by researching key details that make or break deals and educate the buyer on the buying process to create an intelligent buyer.  Prior to SellingRestaurants, Mel was a Chief Financial Officer for Universal Music Group, the largest music company in the world.  There he participated in more than $11.5 billion of merger and acquisition transactions.  He also work for top companies such as Nestle Foods, USA. He hold a Bachelors in Business Administration Finance as well as attened Law School at Gonzaga University.  Give Mel a call at 480.274.7000 or e-mail him at [email protected] if you have any questions. 


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