The Texas Supreme Court recently clarified the standards for enforcing liquidated damage provisions.  As these types of provisions are prevalent in design and construction contracts, the Court’s opinion has particular resonance in the construction industry.

In Atrium Medical Center, LP v. Houston Red C, LLC, the Court held that liquidated damage provisions, to be enforceable, must be “facially reasonable” and must not create an “unbridgeable discrepancy” between actual and liquidated damages.  The Court also clarified which party bears the burden of proving facial reasonableness and unbridgeable discrepancy, and at what moment in time the determinations are made.

1.    Background Facts

At the center of the Atrium dispute was a laundry services contract between ImageFirst, a laundry company, and Atrium, an acute care center.  The contract called for ImageFirst to supply linens to Atrium starting at a negotiated weekly rate and then fluctuating on a weekly basis depending on Atrium’s actual demand for linens.  The larger the demand and the larger the number of linens that were too soiled to be cleaned and reused (so-called “burn rate”), the higher the weekly fee. 

Several months after entering into the contract, Atrium stopped paying ImageFirst’s invoices.  Eventually, Atrium cancelled the contract, triggering a liquidated damages provision.  That provision required Atrium pay a cancellation charge of 40% of the most recent invoiced amount.  Based on that formula, Image First sought and was awarded at trial $716,330 in liquidated damages. 

Atrium appealed the judgment, arguing that the liquidated damages provision was unenforceable under Texas law as it constituted a penalty.  In examining Atrium’s argument, the Texas Supreme Court looked at whether the clause was “facially reasonable” and whether evidence was presented to show that the actual damages were less than the liquidated damage amount.

2.    Facially Reasonable

The first test in determining whether a liquidated damages provision is enforceable is determining whether it is “facially reasonable”.  The party seeking to enforce the provision bears the burden of proof.

“Facial reasonableness” consists of two well-established parts:

• • The harm caused by the breach of contract is incapable or difficult of estimation; and 
  • The amount of liquidated damages is a reasonable forecast of just compensation.

Each of these two parts are examined at the time the parties enter into the contract.

In Atrium, ImageFirst provided evidence that the volume of linens a given center uses is difficult to estimate when a contract is signed as the number of patients at the center can fluctuate.   Similarly, ImageFirst provided evidence that the burn rate is difficult to estimate at the time of contract.  The Supreme Court held that the evidence supported the first part of the facially reasonable test, namely that the damages for breach of contract were difficult to predict when the parties entered into the contract.

As to the second part of the test, ImageFirst presented evidence that, based on its review of the several years’ worth of accounting records for the company, its historical gross profit margin was 40%.  That correlated with the percentage contained in the liquidated damages provision. The Court held that the evidence supported the second part of the facially reasonable test, namely that the liquidated damage amount was a reasonable forecast of just compensation.

3.    Unbridgeable Discrepancy

 Even if a liquidated damage provision meets the facially reasonable test, it may still be unenforceable if an ‘”unbridgeable discrepancy” exists between the liquidated damage amount and the actual damages. The party seeking to prevent enforcement of the liquidated damages clause carries the burden of proving “unbridgeable discrepancy”.  The measurement of actual damages is made at the time the contract was breached. 

In Atrium¸ the acute care center failed to provide sufficient evidence of ImageFirst’s actual losses.  It also failed to provide sufficient evidence that ImageFirst did not mitigate its damages after the breach.  In light of these shortcomings, the Court held that Atrium did not demonstrate an “unbridgeable discrepancy” between the actual and liquidated damage amounts.  The Court affirmed enforcement of the liquidated damage provision and the award of $716,330 in liquidated damages. 

4.    Additional Lessons from Atrium

Aside from clarifying the standards for enforcing liquidated damage provisions, the Court provided some helpful hints about interpreting such provisions.  For instance, it noted that a one-size-fits-all approach to liquidated damages is facially unreasonable, making the clause unenforceable.  In the words of the Court, “provisions that use the same damage measure for breaches of varying magnitude are also facially unreasonable”.  A clause that requires a breaching party pay a multiple of actual damages as the liquidated damage amount is also facially unreasonable.

In addition, the Court noted the importance mitigation of damages to establish that liquidated damages no longer serve as just compensation.  Consideration of how the non-breaching party mitigated its damages is not discretionary: “Courts must consider mitigation when determining whether actual damages diverge significantly from liquidated damages”. 

Liquidated damage amounts can be frighteningly large or unreasonably small.  Regardless of your vantage, the Atrium Court’s standards and shifting burdens of proof assure one thing: The costs associated with enforcing liquidated damages provisions have just gotten higher as parties will start retaining competing experts to prove facial reasonableness or unbridgeable discrepancy. 

As with all issues involving the interpretation of legal rights and remedies, consulting qualified legal counsel is always recommended.  The attorneys in our Austin and Dallas offices are available to answer any questions you may have.  You may contact us at info@gstexlaw.com with any questions you may have.

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