The celebrated “freedom of contract” is not absolute. The right of contracting parties to obligate themselves to one another has always been subject to certain statutory limitations, as well as those imposed by the common-law principles that govern the enforcement of contracts generally. A recent decision by the United States Court of Appeals for the Seventh Circuit, Caudill v. Keller Williams Realty, Inc., 2016 WL 3680033 (7th Cir. July 6, 2016), serves as a reminder of one of those common-law principles—the idea that, as a general rule, parties should not be penalized for breaching a contract. As noted by the Seventh Circuit, quoting a Texas case, an ancient common-law principle declares that damages for breach of contract are limited to providing “compensation for losses sustained and no more; thus, we will not enforce punitive damages provisions.” Punitive damages provisions are clauses that require the payment of a “penalty” for breaching the contract, rather than providing an agreed amount of damages that are designed to actually compensate the non-breaching party for the losses it will sustain in the event of a breach.

But differentiating between agreed damages provisions that are penal in nature and those that are remedial in nature has never been clear cut. Traditionally, a clause providing for payment of an agreed amount for breach of a contract is void as a “penalty” if the purpose of that clause is to punish the breaching party, rather than provide an agreed remedy for breach that is proportionate to the amount of actual damages that could be reasonably anticipated at the time when the contract was made. Or, as noted by the Seventh Circuit, quoting a Texas case, “a liquidated damages clause is enforceable only if ‘the harm caused by the breach [of the contract] is incapable or difficult of estimation and … the amount of the liquidated damages [specified in the contract] is a reasonable forecast of just compensation.’” Accordingly, in an attempt to validate agreed damages clauses as liquidated damages provisions (rather than penalties), U.S. lawyers use some contradictory phrasing that attempts on the one hand to state that the actual damages arising from a particular breach are difficult or impossible to calculate and then at the same time state that the agreed amount is nonetheless a legitimate attempt, as of the date the agreement is entered into, to reasonably estimate the actual damages that will be sustained by the non-breaching party in the event of a breach.

In Keller Williams Realty, the Seven Circuit, applying Texas law, affirmed a federal district court’s refusal to enforce an agreed damages provision that required payment of $10,000 for each unauthorized disclosure of confidential information under the confidentiality obligations of a settlement agreement. Apparently, Keller Williams, the breaching party, had made disclosure of the terms of its confidential settlement with the non-breaching party to 2000 of Keller Williams’ “existing” franchisees as part of a Franchise Disclosure Document that was apparently only required by law to be delivered to “prospective” franchisees. The non-breaching party, therefore, claimed that she was entitled to the payment of $20 million (2000 times $10,000). But because there was no evidence that the non-breaching party had suffered any actual damages as a result of the disclosure, the court refused to enforce the agreed damages clause and instead invited the non-breaching party to prove her actual damages. Quoting an earlier Seventh Circuit decision, the court noted:

[A] liquidation of damages must be a reasonable estimate at the time of contracting of the likely damages from breach, and the need for estimation at that time must be shown by reference to the likely difficulty of measuring the actual damages from a breach of contact after the breach occurs. If damages would be easy to determine then, or if the estimate greatly exceeds a reasonable upper estimate of what the damages are likely to be, it is a penalty.

And despite the fact that the reasonableness of the estimate of actual damages is ordinarily determined at the time the contract is made, the court, quoting a Texas case, declared that “when there is an unbridgeable discrepancy between liquidated damages provisions as written and the unfortunate reality in application, we cannot enforce such provisions.” Because “Keller Williams was able to show that there was no basis for supposing the damages to have been anywhere near an average of $10,000 per unauthorized recipient of the disclosure,” the Seventh Circuit refused to enforce the agreed damages provision.

Interestingly, last November, in the birthplace of the common-law principle at work in the Keller Williams case, the U.K. Supreme Court revamped this common-law principle in a pair of cases: Cavendish Square Holding BV v. Talal El Makdessi, and ParkingEye Limited v. Beavis, [2015] UKSC 67. In one of the two cases noted above, ParkingEye, Mr. Beavis had complained that an £85 charge for overstaying the paid-for 2-hour time limit for parking in a commercial parking lot was an unenforceable penalty because it bore no relationship to the actual losses the parking lot sustained from such a breach of the parking contract. The other case, Cavendish Square, involved a stock purchase agreement providing for the sale of approximately 60% of the shares of the company, with the sellers retaining 40%. The agreement included covenants not to compete by the selling stockholders. The agreement also provided for the purchase price to be paid in installments and stated that if any seller breached the non-compete such seller “shall not be entitled to receive the Interim Payment and/or the Final Payment.” These payments amounted to $147,500,000. Furthermore, the agreement also provided that the defaulting seller’s remaining shares were subject to being repurchased, in the event of a breach of the non-compete, at a price that was determined on a basis that excluded “goodwill.” Again, the argument here was that both of these provisions were penal in nature, rather than remedial, and thus were unenforceable.

The complainants lost in both of these cases; and, in so deciding the cases, the U.K. Supreme Court declared a new rule that would govern the determination of the penalty/liquidated damages divide in jurisdictions for which the decisions of the U.K. Supreme Court are binding precedent. In essence, the new rule is that the determination for whether a clause providing for “financial consequences” upon a breach of contract is a penalty depends not on whether the clause was designed to deter breach rather than provide a legitimate pre-estimation of actual damages that may be incurred. Instead, a clause that deters breach and fails to be a legitimate pre-estimation of actual damages will not be judged penal unless the clause “imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.” And the legitimate interests of the innocent party are not limited to just ensuring that they are fairly compensated for a subsequent breach (e.g., protecting business goodwill is a legitimate interest). Thus, agreed financial consequences still have to be proportionate and not outrageous, but the justification for those consequences is no longer limited to the question of whether they fairly pre-estimate actual damages.

It is not clear to this author how the U.K. Supreme Court would have determined the outcome of the Keller Williams case using this new standard given the fact that the non-breaching party appears to have argued that the clause was designed to protect her reputation by keeping the terms of the settlement confidential for fear that her potential business partners might be reluctant to do business with her should they become aware of the terms of the settlement agreement. But, applying the old common-law standard in the U.S., the Seventh Circuit refused to enforce the clause in the absence of evidence that “a single recipient had come to think less of [the non-breaching party] or her company as a result of [the disclosure], or a single referral that she had lost—failures of proof that demolished her claim to $20 million in damages.” Perhaps the result would still have been the same under the new standard in the U.K. but for a different reason—the agreed damages may have been deemed to be “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”– in this case the confidentiality obligation. But who knows?

Parties relying on agreed damages clauses on both sides of the Atlantic should continue to draft such provisions based upon the current interpretation, in the applicable jurisdiction, of the ancient principle of the common law that abhors a penalty for a contractual breach.