Under what circumstances does a liquidated damages clause of a contract become an unenforceable penalty

Under what circumstances does a liquidated damages clause of a contract become an unenforceable penalty? How do courts interpret these clauses?
When determining whether a contract’s liquidated damages clause constitutes an unenforceable penalty, courts tend to examine the following four factors:

• The entire contract in light of its text;

• What the contract is about;

• The parties’ intentions; and

• The ability of measuring actual, probable damages.

In Commonwealth of Pennsylvania, Department of Transportation v. Interstate Contractors Supply Company, 568 A.2d 294, 130 Pa. Cmwlth. 334 (1990), a Pennsylvania Commonwealth Court dealt with these questions.
Interstate entered into a contract with Penn-DOT to paint and clean six Allegheny County bridges, within 61 consecutive days. At Interstate’s request, PennDOT issued the Notice to Proceed six days before the anticipated time listed in the contract.
During the project, it rained and snowed for 27 days out of the 61. As a result of flooding, two of the six bridges were damaged, requiring extra work. PennDOT granted a seven-day extension and issued a change order for the additional work required.
PennDOT imposed liquidated damages on Interstate at $200 per day for 47 days and at $50 per day for eight days, for a total of $9,800. PennDOT later gave credit in the amount of $1,200 at $200 per day for six days because of its early issuance of the Notice to Proceed. Interstate filed suit against Penn-DOT, arguing that the liquidated damages clause constituted an unenforceable penalty.
Can’t ignore the four
The Board of Claims entered judgment in favor of Interstate in the amount of $8,600. The board determined that the liquidated damages clause constituted an unenforceable penalty because the assessed damages were not an estimate of probable damages, but a form of punishment designed to prevent breach. The board noted that PennDOT did not allow any extension days due to the weather, except for the seven-day extension for flood damage. In addition, the board found PennDOT had failed to show it incurred any actual damages.
On appeal, PennDOT argued that the board erred in determining that the liquidated damages clause constituted an unenforceable penalty. The Commonwealth Court of Pennsylvania agreed. The court noted that the board failed to consider the four factors necessary in determining whether a liquidated damages clause is enforceable.
In applying these factors, the court first held that the board ignored the plain language of Section 111.01 of the Form 408 Specifications (incorporated into the contract), which provides the following:
"The Department is responsible for delay damages arising only from delays created by its negligent act or omissions. Unless otherwise specified, assume the risk of damages from all other causes of delay."
In this case, it was not "otherwise specified" that the burden was to shift from Interstate to PennDOT. The court concluded that unless parties by contract have indicated otherwise, the contractor is generally presumed to undertake the burden of unanticipated happenings (absent an act of God, the law or actions of the other party).
Regarding the subject matter of the contract, the court noted that Interstate was an experienced contractor who should have known approximately how many working days it would have, considering the unpredictability of springtime weather and the fact that it was forbidden to work on Sundays and holidays. Thus, the subject matter of the contract supported the enforceability of the liquidated damages clause.
As for the parties’ intentions, the court concluded that the parties intended to permit Penn-DOT to assess liquidated damages in the case of delay—regardless of any dissatisfaction, which Interstate argued PennDOT failed to express.
Finally, the court looked at PennDOT’s measurement of damages. Although Penn-DOT did not show actual damages, the court stated that there is no requirement that actual damages be shown in order for liquidated damages to be recovered.
Based on these conclusions, the court awarded PennDOT the liquidated damages.
Contractors should assume the risk of damages from unanticipated happenings—unless otherwise specified. In addition, liquidated damages clauses will generally be held enforceable by the courts—absent extenuating circumstances.