Truth be told, the heading of this article is taken from a common usage, or vernacular, perspective; from a technical, legal perspective, it is simply wrong.

Here’s why: The term “liquidated damages,” at least under New York law, means that a court has determined as a matter of law that the specific amount of monetary damages stipulated to in a contract that are to be awarded to one side in the event of a breach of the agreement bear a rational relationship to the anticipated damages, and are reasonable. (For additional information on this topic, please see “How to Challenge the Validity of a Liquidated Damages Claim Under New York Law“).

But what happens under New York law if the court invalidates the liquidated damages clause? Is all lost?

The short answer is this: No.

Fortunately, the courts have expanded on this concept a bit, and given some guidance on this issue, stating:

“If the clause is rejected as being a penalty, the recovery is limited to actual damages proven” (Brecher v Laikin, 430 F Supp 103, 106 [SD NY 1977] [citations omitted]; see also 3 Farnsworth, Contracts § 12.18, at 304 [3d ed] [where a liquidated damages provision is an unenforceable penalty, "the rest of the agreement stands, and the injured party is remitted to the conventional damage remedy for breach of that agreement, just as if the provision had not been included"]).

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In Meadus v. Rosenthal, a decision surrounding a failed real estate deal that was handed down on November 5, a Brooklyn judge sitting in the Civil Court made an unusual decision, and allowed the seller to keep the buyer’s escrow payment.  Here’s why:

The contract of sale provided that the plaintiff-buyer was going to obtain a bank commitment for a conventional 15-year mortgage at the prevailing interest rate within 30 days in the amount of $190,000. The defendants-sellers became anxious when they didn’t hear back from the plaintiff-buyer, as they had a binder on a new house that was contingent on their ability to sell this one.

It turned out that the plaintiff was turned down for their mortgage due to assorted credit problems, but they deliberately failed to inform the defendants of this problem; instead, they tried to get an FHA loan for substantially more money – over $300,000. This application also failed; and this time, the defendants learned about it because the second bank sent a copy of its initial commitment (which was later revoked) to the defendants’ attorney.

Predictably, defendants’ attorney rejected the plaintiff’s unilateral move to alter the contract, and set closing date with a “time of the essence” for 2 weeks later. After the plaintiff failed to appear at the closing, she brought this action to recover his deposit.

In opining that the seller was entitled to retain the downpayment as liquidated damages, the Court held as follows:

“For several months after the contract price was amended to satisfy [the first bank], plaintiff did not respond to defendants’ several inquiries regarding the closing based on [this bank's] mortgage. There is nothing in the record that remotely satisfies the contractual requirement to “promptly furnish all reports, documents,…in connection [with the mortgage commitment]” to seller. [In addition], plaintiff faults defendants for cooperating with her mortgage company and paints it as a tacit acceptance of her FHA loan application. The “cooperation” was a result of defendants’ own investigation of plaintiff’s mortgage situation that was prompted by plaintiff’s non-responsiveness on the issue.”

While the Court’s decision is clearly limited to the specific facts of this case – rather than announcing a general rule for broad application – it does provide valuable guidance as to the type of circumstances where a seller may be able to retain the downpayment when the deal falls through.

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In many long-term contracts, such as in the services industry, it has become rather commonplace for the service provider to insert a liquidated damages clause, which essentially sets forth the specific damages they will be entitled to if the recipient terminates the contract prematurely.

As I’m sure you know, not all liquidated damages clauses are enforceable under New York law; on the other hand, not all of them are unenforceable either.

To the contrary, New York’s courts have long held (as far back as 1977) that  “a liquidated damages provision is enforceable where the fixed amount bears a ‘reasonable proportion to the probable loss and the amount of actual loss is incapable or difficult of precise estimation’ (JMD Holding Corp., supra, 4 N.Y.3d at 380, 795 N.Y.S.2d at 507 (quoting Truck Rent-A-Center v. Puritan Farms 2nd,Inc., 41 N.Y.2d 420, 425, 393 N.Y.S.2d 365, 369 (1977)).”

New York’s courts have shown an increasing tendency to honor these provisions when they are mutually negotiated between two sophisticated businesses that are on equal, or roughly equal footing; conversely, the courts have refused to honor liquidated damage provisions where they are a penalty that is out of scale with foreseeable losses, or where the provisions are being unilaterally imposed by one side on a far weaker second half to a deal, which is also known as “unconscionability.” JMD Holding Corp., supra, 4 N.Y.3d at 378-85, 795 N.Y.S.2d at 506-10; Stenda Realty, LLC v. Kornman, 67 A.D.3d 996, 889 N.Y.S.2d 639 (2d Dep’t 2009).

As a strictly practical matter, the following bears emphasis: a court’s determination as to the validity – or invalidity – of a particular liquidated damages clause will often have to await the end of a case. And the reason for this should be fairly evident: the relationship – or the lack thereof – between the liquidated damages clause and foreseeable losses is a fact-specific one, and requires a full and detailed analysis of the facts of the case. Consequently, as part of your initial contract negotiations, you should consider whether this provision will have enough bite to make it worthwhile to litigate down the line, if this deal ultimately falls apart.

Stated differently (and to quote many of my gurus, including a 15th century mystic): begin with the end in mind.

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