Are Liquidated Damage Clauses in Construction Contracts at Risk of Being Declared an Unenforceable Penalty?
In the wake of an Arizona Supreme Court ruling, a liquidated damage clause may not stand up in court if it fails to reasonably estimate the parties’ construction-related damages
at the commencement of the construction contract.
In an April 2017 ruling, the Arizona Supreme Court found a liquidated
damage clause to be unenforceable as a penalty in
Dobson Bay Club v. La
Sonrisa De Siena. In this non-construction case, Dobson Bay had signed a
$28.6 million promissory note secured by a deed of trust recorded against four
commercial properties. The promissory note required interest-only payments with
a balloon payment upon maturity. The note also provided for default interest,
collection costs, reasonable attorney fees, and a 5% late fee.
When Dobson Bay failed to pay the balloon upon maturity,
La Sonrisa started foreclosure proceedings against the commercial properties and
assessed a $1.4 million late fee. Dobson Bay refinanced the note, paid all
principal and undisputed interest, and deposited the $1.4 million late fee with
the court, claiming that the late fee was unenforceable as a penalty.
The Supreme Court reviewed existing Arizona law on
liquidated damages, noting that liquidated damage clauses can increase certainty
and decrease risk exposure, proof problems, and litigation costs.
The Court then adopted a two-part test for enforcing a
liquidated damage clause in deciding whether the parties' damages forecast was
reasonable. Under that test, the forecast is reasonable if it approximates
the loss anticipated at the time of contract
creation (despite any actual loss), or
the loss that actually resulted (despite what
the parties might have anticipated in other circumstances).
The Court also stated that the non-breaching party is
not required to prove actual damages to enforce a liquidated damage provision,
and a court will respect the parties' agreement if it is reasonable in relation
to the anticipated or actual loss.
The Supreme Court applied these factors to the late-fee
clause, finding it unenforceable because $1.4 million was not a reasonable
forecast of anticipated damages resulting from an untimely balloon payment.
Applying this decision to Arizona construction
contracts, parties seeking to enforce a liquidated damage clause in their
construction contracts should anticipate future Dobson Bay-based arguments if
the liquidated damage provision does not reasonably estimate, at the beginning
of the contract, the parties' construction-related damages.