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The Penalty Provision That Wasn’t

Construction & Contractor Disputes, Real Estate Law, and Real Estate Law Litigation by Peter N. Brewer, Esq.

Under California law a “penalty provision”, or an unreasonable liquidated damages provision, is not enforceable.  Over the years public policy has changed to allow for more stringent enforcement of these provisions.  For example, the standard real estate purchase contract has an optional provision for liquidated damages.  Along with the expansion of liquidated damages, courts have begun to interpret these provisions to favor enforceability.  Most recently, in McGuire v. More-Gas Investments, LLC, a California appellate court found that a penalty provision was, in fact, just a provision that allowed a party to choose between two alternative means of contract performance, and was enforceable.

Facts

In May 2006, Brian and Shirley McGuire purchased two lots from More-Gas.  As part of the purchase, the McGuires required More-Gas to obtain agreements from three nearby lot owners to not build within 900 feet of the access road adjoining the McGuires’ properties within a year of closing.  If More-Gas failed to do that, they would be required to refund the McGuires $80,000.  The parties agreed that at the time they agreed on the $80,000 figure, no one had researched how much the McGuires would actually be harmed if the restrictions were not obtained.  A year passed and More-Gas failed to get the restrictions from the nearby lots.  Accordingly, the McGuires sued to obtain the $80,000 refund.

Holding

At the trial court level, More-Gas prevailed based on the theory that the provision was an unenforceable penalty.  In order for liquidated damages to be enforceable the parties must have reasonably tried to estimate a fair compensation for the damages sustained by the non-breaching party.  As the parties agreed that no one had performed any research to determine how much the McGuires would be harmed if the agreements were not obtained, the trial court found that the provision was an unenforceable penalty provision.

However, the appellate court reversed the lower court, determining that the provision was not actually a damages provision but instead merely gave More-Gas a choice on how to perform the contract.  Here, More-Gas was given a reasonable choice to either obtain the agreements of the other owners or to pay $80,000.  Unlike a situation where a party has a choice to pay a lower amount or pay a higher amount later because of a default, which would be a penalty, More-Gas had two rational choices to pick from.

Takeaway

This decision expands the acceptability of provisions that might have previously been considered a penalty.  Essentially the Court found that almost any provision would be enforceable so long as it provided a rational choice, even if this means paying as much as 25% of the purchase price as an alternative form of performance.  Liquidated damages provisions that remain prohibited appear to be provisions where a larger liability will be incurred if prompt payment is not made, i.e., pay $100 by the 10th or $200 after that.  If you are a party looking to be protected by these provisions, make sure that the provision is “reasonable”.  This is a fact specific inquiry, and we would recommend getting legal assistance before entering into such an agreement.

If you have questions regarding real estate matters and are seeking legal counsel, we would be happy to help.  We can be reached at (650) 327-2900 or to find out more about our law firm please visit us at www.BrewerFirm.com.

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