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Liquidated Damages Provisions In Real Estate Contracts: Not Automatically Enforceable
Law And Policy
Under Tennessee law, when the buyer defaults under a real estate sale contract, the seller can recover damages, which can include the difference between (a) the sale price under the failed contract and (b) the sale price under the new contract with a third party.
The buyer does not want to be exposed to the uncertainty of the price at which the seller may sell the property to a third party, as this could be considerably less than the price under the failed contract. In commercial contracts, the buyer typically tries to negotiate for the seller to retain the earnest money deposit as the seller's sole remedy. The seller often counters by asking for a substantial amount of earnest money, designed to cover the seller's potential damages. Retaining the earnest money is known as a liquidated damage provision, which says that the amount of the earnest money is the parties' best estimate of the actual damages.
The recent Bachour case illustrates that a court can second guess the parties' determination of the amount of liquidated damages. Interestingly, in the Bachour case, it was the seller who defaulted, but the principles remain the same.
The seller and the buyer entered into a contract for sale of property for $275,000, with $200,000 payable at closing and the remaining $75,000 paid when the seller completed roads to the property. If the roads were not completed by a certain date, then the buyer retained the $75,000 as liquidated damages. The deadline was not met, but in court the seller claimed that the $75,000 amount was an unenforceable penalty instead of liquidated damages.
The court noted that parties are generally free to agree to whatever contract provisions they desire, except that provisions for penalties for default are void as against public policy and will be subject to "close scrutiny" by a court. To avoid being characterized as a penalty, the amount of liquidated damages must bear a reasonable relationship to the amount of damages reasonably expected in the event of a breach.
In Bachour, the buyer was unable to articulate at trial the amount of damages he expected when he entered into the contract. Instead, the $75,000 amount was determined arbitrarily by the buyer and presented to the seller without discussion. Further, the buyer was unable to show any actual damages, and his case was not aided by his pre-trial deposition testimony referring to the $75,000 as a "heavy penalty." The court ordered the buyer to pay the $75,000 to the seller.
The Bachour case is an extreme example of a difference between the amount of liquidated damages and the amount of damages reasonably expected in the event of breach. Contracting parties are almost always guessing at to what the amount of the damages may be, and the Bachour court interjected a look-back element into the analysis by discussing actual damages. How can an unfavorable result like this be avoided?
- In the Bachour case, the parties could have used a different mechanism for the road construction. The $75,000 could have been escrowed under a joint construction agreement, so that the buyer could have had more control over the process and avoided a failure to timely complete the road. Of course, the failure of the buyer to have insisted on this approach showed that, as the court found, the completion of the road was not that critical to the buyer.
- One commentator on the Bachour case has suggested that it is possible that the non-defaulting party could claim that the liquidated damages amount is an unenforceable penalty. This would open the door to the non-defaulting party claiming more damages than under the liquidated damages provision. So, if either party can potentially avoid the liquidated damages provision, then where are the parties left?
- If the liquidated damages amount is void, can the seller, as the non-defaulting party, then recover actual damages, even if the contract states that the liquidated damages provision is the seller's sole remedy? Or in the Bachour case, could the buyer, if his actual damages were higher than $75,000, have claimed that the liquidated damages provision was void and sought the higher actual damages?
- Should the contract say what happens if the liquidated damages provision is unenforceable? If so, what would happen? Perhaps the contract could say that the amount of liquidated damages is intended to be enforceable and that if a court finds the amount to be too high, it should reduce it to an enforceable amount. One problem with that approach is that it demonstrates to the court a lack of confidence in the liquidated damages amount. However, this "blue pencil" approach has appeared to work in covenants not to compete, where otherwise the covenant would be declared completely unenforceable for being overly broad in time or territory.
- Another approach is to put a monetary cap on damages. This means that the seller has to have actual damages to recover, but the seller cannot recover more than the cap. This protects the buyer from an unexpectedly large amount of damages.
- A variation on the monetary cap is to limit the type of damages. For example, the seller can be limited to recovering actual out of pocket expenses to third parties (such as for surveys, soil tests and environmental tests). The seller cannot recover for difference in sales price or other damages. Similarly, a buyer, in the event of a default by the seller, could be limited to recovering actual out of pocket expenses to third parties and not lost profits and other speculative damages. This could be combined with a right to specific performance (see post on that subject).
One of the benefits of a well-designed contract is that it clearly sets forth the expectations of the parties if things do not go as planned. While parties are generally free to form their own real estate contracts, the Bachour case reminds that they need to carefully craft their default provisions to avoid unexpected adverse results, such as, in the case of a liquidated damages provision, having a court void the provision.
 Bachour v. Mason (Tenn. App. May 31, 2013
 . C. Dewees Berry, IV, Tennessee Real Estate Law Letter, October, 2013.