Recent Texas Supreme Court case offers important industry wide lessons in enforceability
Liquidated damages are well known within the construction industry. Typically, parties designate damages for a specific breach of contract when some types or amounts of damages are difficult to forecast at the time of contracting. Construction contracts include liquidated damages for project delays because damages caused by delays are difficult to foresee. Liquidated damages may be assessed by owners for failure to timely complete a project, or may be claimed by contractors when delays increase the costs of project completion. Certain limitations apply to the damages that may be claimed by a party. Given the prevalence of these clauses, contractors would be wise to know these limitations, including the occasions where a clause would be unenforceable because it results in a penalty.
In FPL Energy, L.L.C. v. TXU Portfolio Mgmt. Co., L.P., 57 Tex. Sup. J. 325 (Tex. 2014), the Texas Supreme Court reviewed the enforceability of a liquidated damages clause in an electricity contract. The Supreme Court overturned an appellate court decision awarding liquidated damages to TXU Portfolio Management (TXU). Because the liquidated damages were unreasonable, the clause was unenforceable. Although the decision focused on an electricity contract, the Court’s interpretation provides a teachable moment for parties subject to liquidated damages clauses.
TXU was required by state law to produce a certain amount of renewable energy credits. TXU entered a contract with FPL Energy (FPL) where FPL would sell TXU some of those credits. If FPL did not meet the credit requirement of the contract, the liquidated damages clause required FPL to pay TXU $50 for every credit it was short. TXU sued FPL for breach of contract seeking liquidated damages for FPL’s failure to meet the credit requirement in the contract. The appellate court awarded TXU $29 million in liquidated damages. FPL appealed to the Texas Supreme Court arguing against enforcement of the liquidated damages clause.
At first glance, the case has nothing to do with construction. The parties deal in the energy industry, not construction. However, the enforceability of the liquidated damages clause is central to the Court’s decision and is applicable to contracts throughout the construction industry.
When a party asserts liquidated damages are owed pursuant to a liquidated damages clause, both of the following requirements of a two-part rule must be present when the parties entered the contract: (1) the harm caused to the non-breaching party by the breach must be either difficult or incapable of estimate; (2) the amount of liquidated damages called for in the clause must be a reasonable forecast of just compensation for the breach. The Court focused its enforceability analysis on the second requirement of the test.
Actual damages suffered by a party are essential to the second element of the test. If the liquidated damages have no rational relationship to the non-breaching party’s (in this case, TXU) actual damages, the liquidated damages are unreasonable and the liquidated damages clause is unenforceable as a penalty. In the FPL case, the Court found that FPL had proven that TXU incurred approximately $6 million in actual damages. Due to the vast discrepancy from the $29 million in liquidated damages awarded by the appellate court and the actual damages incurred by TXU, the Texas Supreme Court determined the liquidated damages had no rational relationship to actual damages and were unreasonable and unenforceable as a penalty.
THE LESSON
The outcome of the decision offers lessons for contractors around the country. The highest state courts in Alaska, Maryland, New Jersey, and Washington, and the 9th Circuit Court of Appeals at the federal level, utilize the two-part rule to scrutinize liquidated damages clauses.1 The courts in each of those jurisdictions applied their own version of the two-part rule, requiring actual damages to be difficult or incapable of estimate and the liquidated damages be a reasonable forecast of just compensation.
Because this decision reflects the stance of many courts around the country, contractors can take valuable lessons from the Court’s application of the two-part rule. When a court considers the reasonableness of the liquidated damages, it does so from the viewpoint of the parties at the time of contracting. However, the liquidated damages may be unreasonable in light of the actual damages incurred by a non-breaching party. In other words, even if the liquidated damages are reasonable at the time of contracting, they can be unreasonable in application if actual damages are far less than liquidated damages. When such a claim is made, the burden of proving the amount of actual damages is on the party arguing that the liquidated damages are unreasonable. In the construction industry, that would require proof of the extent to which the non-breaching party was harmed by any construction delays that give rise to liquidated damages. Information contained in invoices, payment applications, correspondence, the liquidated damages clause’s language, and other sources can be utilized to prove actual damages. From there, the amount of proven actual damages can be used to show that the liquidated damages are punitive. Courts do not allow punitive liquidated damages clauses to be enforced. In a situation where the unreasonableness of a liquidated damages clause can be proven in light of the actual damages, the clause is a penalty and unenforceable.
The inclusion of liquidated damages clauses is commonplace in construction contracts. Knowing what is required for those clauses to be enforced is useful information for either party to a construction contract, whether attempting to enforce a liquidated damages clause, or trying to defeat its enforcement.
1 Carr-Gottstein Props. v. Benedict, 72 P.3d 308, 311 (Alaska 2003); Barrie Sch. v. Patch, 933 A.2d 382, 390 (Md. 2006); Wasserman’s v. Twp. Of Middleton, 645 A.2d 100, 106–07 (N.J. 1993); Wallace Real Estate Inv., Inc. v. Groves 881 P.2d 1010, 1015 (Wash. 1994); Idaho Plumbers & Pipefitters Health & Welfare Fund v. United Mech. Contractors, Inc. 875 F.2d 212, 217 (9th Cir. 1989).
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About the Author JD Holzheauser is an associate with Ford Nassen, which is nationally recognized in the construction industry and one of the largest construction law firms in Texas. Mr. Holzheauser represents contractors, subcontractors, owners, developers, and suppliers on diverse construction matters, including resolution of disputes. Reach him at jdholzheauser@fordnassen.com or 512.236.0009.
