Liquidated Damages vs. Penalties in a Contract – Cause for Confusion

It is a long standing principle that contract terms will be upheld unless there is a specific reason they should not be, for example if they were made under duress or their terms are unconscionable. Penalty clauses are not in the “safe’ clauses category. They are often at risk of being invalidated. 

Clauses that address damages for a breach of contract are allowed, but not always. New Jersey law allows for which is called “liquidated damages,” which are those that “a party . . . agrees to pay if he breaks some promise, and which, having been arrived at by a good faith effort to estimate in advance the actual damage that will probably ensue from the breach, [are] legally recoverable as agreed damages if the breach occurs.”  

In contrast, a penalty is “the sum a party agrees to pay in the event of a breach, but which is fixed, not as a pre-estimate of probable actual damages, but as a punishment, the threat of which is designed to prevent the breach.” New Jersey courts further differentiate these two by attempting to find out whether the amount is a “reasonable forecast” of what fair compensation for the harm contemplated would be – or whether the harm is difficult or incapable of happening.  

A New Jersey Appeals Court recently explored this in Jet Star Realty, LLC v. Fresh Food Direct, LLC.  Jet Star was a landlord of commercial real estate space rented by Fresh Food Direct, which ended its lease with Jet Star before the end of its term – and then agreed to a settlement to cover the disputed amount of rent that it owed.

The settlement required Fresh Food to pay $20,000 in 6 equal monthly installments of $3,333.33. If Fresh Foods defaulted on its payments for any reason and did not cure the default within 10 days, it would have to pay a penalty of $25,000, less any payments already made. 

Fresh Foods final payment was 15 days past the default date, for a total of $20,000. Jet Star  accepted the payment. Under the settlement, the penalty for the late payment was therefore $5,000.  

Jet Star went to court for the penalty at the same time it accepted the last installment payment. But the judge who heard the case unexpectedly decided that the last payment being 15 days late did not justify a $5,000 extra penalty on Fresh Foods. It is not “just compensation” and therefore was unreasonable and unenforceable.  An Appeals Court agreed. 

This result shows the unfortunate unpredictability of our court system – a settlement should be enforced. But it also is a warning that it’s important to have terms in a contract that explain the reason for damages for a breach – and that are “reasonable” and “fair.” Courts will not always uphold a contract, even one that is a settlement of a dispute. The risk can be minimized, though, if an attorney at least helps you to better decide what is “liquidated damage” vs. a “penalty.” It is not always clear, even to a judge.