Are liquidated damages clauses enforceable in Delaware?

(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.

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Liquidated damage clauses have long been recognized in Delaware. In re Ross & Son, Inc., Del.Ch., 95 A. 311 (1915). They are enforceable where damages are uncertain and the amount agreed upon is reasonable. Lee Builders v. Wells, Del.Ch., 103 A.2d 918, 919 (1954). If, however, damages from breach are easily ascertainable or the amount fixed is excessive, the provision is void as a penalty. Wilmington Housing Authority v. Pan Builders, Inc., D.Del., 665 F.Supp. 351, 354 (1987).

"[L]iquidated damages, by definition, are damages paid in the event of a

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breach of contract."⁸⁶ Delaware Courts routinely enforce liquidated damages provisions when damages are uncertain at the time of contracting and when the liquidated damages due are reasonable.⁸⁷ The role of liquidated damages is to compensate, not to punish; if such a provision is aimed at "punish[ing] the breaching party or ensur[ing] performance, the provision is void as a penalty."⁸⁸ As a part of its liquidated-damages-vs.-penalty analysis, a court should figure out the parties' intent when contracting.⁸⁹

Delaware courts engage a two-step examination to determine whether a liquidated damages provision is valid, or whether it represents a penalty and is thus void.⁹⁰ The first inquiry is whether "damages were uncertain" at the time of

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contracting.⁹¹ The second discerns whether the liquidated damages sought are reasonable.⁹² "To fail the second prong . . . the amount at issue must be unconscionable or not rationally related to any measure of damages a party might conceivably sustain."⁹³

Liquidated damages provisions embody "the parties’ best guess of the amount of injury that would be sustained in a contractual breach" and serve to make "certain and definite damages which would otherwise be uncertain and not susceptible of proof." ⁹⁴ In contrast, a penalty is a "punishment for default, rather than a measure of compensation for ... breach," that inserts with blunt instruments "a stipulated sum ... irrespective of the damage sustained." ⁹⁵ To ascertain the difference, the Court conducts a two-prong analysis that probes the "intent of the parties"—"a mixed question of law and fact." ⁹⁶ First, the Court must determine whether damages were certain, i.e. , capable of "accurate calculation," at the time of contracting. ⁹⁷ If

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damages were calculable with a fair amount of precision, then a clause that concocts an aggravated total is a penalty. And second, if damages were uncertain or at least could not be forecasted reliably, then the Court must determine whether the amount selected is reasonable. ⁹⁸ At this step, the Court will not strike that number merely because the cost "has become financially inconvenient for [a counterparty] to honor[.]" ⁹⁹ Instead, to be unreasonable, "the amount at issue must be unconscionable or not rationally related to any measure of damages a party might conceivably sustain." ¹⁰⁰

Delaware enables sophisticated counterparties to contract as they wish and her courts are loath to disturb bilaterally-negotiated terms. ⁸⁵ Pro-contractarian, "Delaware law in general recognizes that

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the value of contracts is maximized by enforcing them as written [and that] little value can come of a promise that can be avoided upon the remorse of the maker thereof." ⁸⁶ Indeed, Delaware law promotes voluntary business arrangements "as a matter of fundamental public policy." ⁸⁷

Still, Delaware's fundamental public policy of contractual enforcement is not absolute and will kneel to competing public policies of overriding concern. ⁸⁸ When the fruits of a bargain are tainted by unsavory objectives, "our courts will decline to enforce [them], no matter how clear or sincerely intended when entered." ⁸⁹ The inclusion of penalties disguised as liquidated damages provisions presents one such constraint on the freedom of contract. ⁹⁰ This is so because "[c]ontract law allows parties to establish only a good faith estimation of actual damages sustained as a result of a contract's termination." ⁹¹ That the line separating good and bad faith recompense is often thin makes close scrutiny appropriate. ⁹² After all, "[t]he distinction between a penalty and liquidated damages clause is significant—if a provision is ... a penalty, it is void as against public policy ...; if the provision is a true liquidated damages provision, it will be enforced according to its own terms." ⁹³