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 either:

• 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.

Construction Cases

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.