Damages incurred because of a breach of contract are defined as liquidated damages. In order to avoid liquidated damages, parties must determine what is viable in advance. In California, if liquidated damages do not have a reasonable relationship to the amount of anticipated damages then they are unenforceable.
Penalty or Forfeiture of Liquidated Damages
The case of Ridgley v Topa Thrift & Loan Ass’n in 1998 found that `The amount established as liquidated damages “must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained. In the absence of such relationship, a contractual clause purporting to predetermine damages ‘must be construed as a penalty.’”
In this case, a loan agreement was the issue. If the borrowers were more than 15 days late to paying the interest payment or defaulted on any contract provision, the agreement required the borrowers to pay the lender a prepayment fee of 6 months interest when the property collateral was sold. The borrowers were late with one interest payment, but were able to sell the property before the loan matured. Under the demand of the lender, they repaid the loan principal with prepayment fee.
Because the prepayment fee had no relationship to the potential damages of a late interest period, the court held that the prepayment fee was a penalty and unenforceable. Under this clause, it made any late interest payment result in a serve penalty. This was created in order to coerce timely payments of interest, not to compensate a lender for interest payments.
Cal. Civil Code of Proc. Section 3275 states, “Whenever, by the terms of an obligation, a party thereto incurs a forfeiture, or a loss in the nature of a forfeiture, by reason of his failure to comply with its provisions, he may be relieved therefrom, upon making full compensation to the other party, except in case of a grossly negligent, willful, or fraudulent breach of duty Under §3275, any contractual provision by which money or property could be forfeited regardless of the actual damage suffered may be unenforceable as a penalty. If a liquidated damages clause is found to be a penalty, the party that has suffered damage may collect only the amount of actual damages it has sustained.”
One way to avoid liquidated damages is to repay a loan before maturity. This is not considered a breach of a loan agreement, but an alternative. In this case, the prepayment charge is an agreed form of compensation.