Alert: "SCOTX Affirms Second-Look Approach for Liquidated Damages, Clarifies Each Side's Burdens"

Nearly six years after its opinion in FPL Energy, LLC v. TXU Portfolio Mgmt. Co.,¹ the Texas Supreme Court once again took up the issue of whether liquidated damages constitute an unenforceable penalty in Atrium Medical Center, LP v. Houston Red C LLC.² In upholding the enforceability of the liquidated damages clause (LD clause), the Court, as in other recent contract interpretation cases, emphasized Texas’s strong policy favoring freedom of contract. That policy, however, is tempered by the universal rule that damages for breach of contract cannot exceed just compensation for the actual loss. Liquidated damages are intended as a substitute for actual damages. Thus, an LD clause that produces a liquidated damages amount that exceeds just compensation—either in design or operation—constitutes a penalty and is unenforceable.

The Court confirmed that Texas is a Second-Look jurisdiction with respect to the test to determine enforceability of the LD clause. It clarified that the party seeking to enforce the LD clause (usually the plaintiff) bears the initial burden to show that at the time the agreement was executed (1) the harm caused by the anticipated breach was incapable or difficult of estimation, and (2) the amount of liquidated damages called for was a reasonable forecast of just compensation. Phillips v. Phillips.³ If those two requirements are satisfied, then a party seeking to invalidate the LD clause may try to show an “unbridgeable discrepancy” between the actual damages incurred at the time of breach and the stipulated damages under the LD clause (the Second-Look). If there is an “unbridgeable discrepancy” between the actual damages and the liquidated damages, the estimate was in reality not an accurate forecast of just compensation and the clause will be invalidated as a penalty.

In discussing the evidence relating to actual damages, the Court disapproved of several lower court opinions that held a claimant’s failure to mitigate the breach of contract was not to be considered in this analysis. It explained that evidence showing the claimant could have mitigated the breach to reduce the claimant’s actual damages can be used by the challenger to increase the difference between the actuals and the liquidated damages for proving an unbridgeable discrepancy. In effect, the party challenging the LD clause may show an unbridgeable discrepancy by proving the other party’s actual damages and failure to mitigate.

For contract drafters, the Atrium opinion reinforces that at the time of contracting parties must carefully consider, and perhaps reflect in the LD clause itself, facts and circumstances that explain why the harm sought to be addressed is incapable or difficult of estimation and why the amount specified in the clause is a reasonable forecast of just compensation. For example, parties might recite existing market circumstances, uncertainties in expected performance, ranges of pricing, or other data and information. This will not automatically make the LD clause enforceable, but it will inform the court interpreting the clause in hindsight about how the parties arrived at the LD amount. If one of the parties later seeks to invalidate the LD clause, that party should be sure to designate an expert to calculate the opponent’s actual damages and any failure to mitigate to have the best chance of demonstrating the unbridgeable discrepancy.

¹              426 S.W.3d 59, 72 (Tex. 2014).
²              No. 18-0228 (Tex. Feb. 7, 2020).
³              820 S.W.2d 785 (Tex. 1991)