As part of a contract, parties can include a clause identifying damages to be paid for nonperformance of the contract. But there are limits to the amount that the parties can agree upon.

For example, a liquidated damages clause identifies a damages amount that the parties have agreed upon. To be a valid liquidated damages clause, the agreed-upon amount must be calculated based on a reasonable estimation of the amount that one party would actually lose if the other party were to breach the contract. However, if the amount agreed upon is excessive, meaning that the amount is so large that it is obviously disproportionate to any likely damages amount that would result from a breach of contract, then the amount is a penalty and is unenforceable. See Lewis v. Premium Investment Corp., 568 S.E.2d 361, 363 (S.C. 2002).

Whether an amount is considered liquidated damages or a penalty depends on the intention of the parties, not upon the language used in the contract. Moser v. Gosnell, 513 S.E.2d 123, 126-7 (S.C. Ct. App. 1999) (citing Benya v. Gamble, 321 S.E.2d 57 (S.C. Ct. App. 1984)). In Moser, the Gosnells sold most of the assets of their full service construction and carpet cleaning business to the Mosers. The sale agreement included a covenant not to compete which stated that the Gosnells could not engage in the same kind of business that they did prior to selling to the Mosers. If the Gosnells did breach the covenant not to compete, they would have to pay the Mosers damages in an amount equal to the purchase price for the business, which was $585,000. The Gosnells breached the covenant not to compete and the Mosers sued, asking for liquidated damages of $585,000. The Court of Appeals found that the language of the covenant clearly showed that the purpose of the damages provision was to deter the Gosnells from breaching the covenant and to punish them in the event that they did breach. At the time the Mosers and Gosnells signed the agreement, the parties could not reasonably have believed that any probable damages resulting from breach of the covenant would amount to $585,000. In fact, the actual damages the Mosers suffered due to the Gosnells’ breach amounted to a few thousand dollars. The court determined the damages portion of the covenant not to compete was an unenforceable penalty because it was designed to deter a breach and to punish the Gosnells if they did breach.

What this means for you:

• Valid liquidation damages clauses are enforceable. Penalty clauses are not enforceable.
• Merely labeling the provision as a "liquidated damages" clause does not prevent it from actually being an unenforceable penalty.
• If the parties reasonably intend for the amount to match actual damages that would occur for nonperformance, then the amount constitutes liquidated damages and is enforceable.
• If the amount is intended to punish the party who breaches the contract, it is a penalty and is unenforceable.

This site and any information contained herein is intended for informational purposes only and should not be construed as legal advice. Seek competent legal counsel for advice on any legal matter.