Penalty vs. Liquidated Damages

July 17, 2019

When people draft contracts, a natural tendency is to make penalties for non-compliance fairly harsh. After all, if the penalty is bad enough, then the parties will be encouraged to do what they agreed to do instead.

In Georgia, however, a contract provision that provides for a “penalty” is unenforceable. On the other hand, it is possible for the parties to agree in advance on a “liquidated damages” provision, i.e., if A breaches his contract with B, the liquidated damages provision would dictate what A owes B as a result.

Naturally, whether a provision provides for liquidated damages or a penalty is an issue that has led to a fair amount of litigation, and there is a sizable body of case law on the subject. The seminal case under Georgia law that the Court will use to determine whether a particular provision provides for liquidated damages (which is enforceable) as opposed to a penalty (which is not enforceable) is Southeastern Land Fund, Inc. v. Real Estate World, Inc., 237 Ga. 227 (1976), which provides in relevant part as follows:

“In deciding whether a contract provision is enforceable as liquidated damages, the court makes a tripartite inquiry to determine if the following factors are present: First, the injury caused by the breach must be difficult or impossible of accurate estimation; second, the parties must intend to provide for damages rather than for a penalty; and third, the sum stipulated must be a reasonable pre-estimate of the probable loss. [Cits.]” 237 Ga. at 230.

While it’s not always as simple as merely including the above language in the contract as a way to avoid a court ultimately finding a provision is an unenforceable penalty, inclusion of language that is designed to satisfy this test can go a long way toward protecting you down the road. I also recommend avoiding words like “fee”, “forfeit”, and of course, “penalty”. And, if there is something in your contract that clearly has no rational relationship to a probable breach and really is simply a penalty, you’re better off taking it out now than you will be if you force a court to strike it later.