Bankers and other business persons should carefully consider a significant change this year to the state’s law regarding contractual default clauses. The change was made by a little-noticed Ohio Supreme Court decision that requires the fairness of such clauses to be assessed from the perspective of the relationship of the parties at the beginning of the contract.  In the case at issue this led to enforcement of an extreme damages claim.

These clauses are commonly called “liquidated damages clauses” because they impose a definite economic cost on the defaulting party when a contract is breached. Such clauses are ubiquitous.  They are most frequently found in construction contracts and in public construction contracts they are often required by the law applicable to governmental bodies.  The clauses are also found in other types of business contracts frequently encountered by bankers such as IT vendor contracts, consulting contracts, contracts for the supply and delivery of equipment, and other contracts for the sale of goods and services where time is of the essence.

In Boone Coleman Constr., Inc. v. Piketon, 145 Ohio St. 450, 2016-Ohio-628, the Ohio Supreme Court suggested it was merely extending an existing precedent on contractual liquidated damages provisions to public-works contracts.  The Court ruled that liquidated damages provisions, including per diem charges for delayed performance, must be reviewed only from the standpoint of the parties at the time the contract was executed. The Court clarified existing Ohio liquidated damages law by holding that liquidated damages provisions shall not be invalidated based upon the equities at the time of the breach.  The holdings are not limited to public-works contracts however even though the case itself was a public works case.

Boone Construction was awarded a contract to install a traffic light and make improvements to the roadway on U.S. Route 23 in the Village of Piketon. The contract expressly provided that time for completing the project was “of the essence.”  Because the project was funded with state money, the contract was required to have a per diem liquidated damages provision for the contractor’s failure to complete the project by the agreed upon completion date.  The contract price was $683,300 and the liquidated damages provision required Boone to pay $700 for each day completion was delayed.  Boone was 397 days late in completing the project and the liquidated damages aggregated to $277,900, wiping out 40% of the contract price.  Boone argued that the liquidated damages provision, as applied, was an unenforceable penalty rather than a reasonable substitute for actual damages.  The court of appeals agreed.  The Supreme Court did not.

The majority opinion sets out the precedent to be applied: “Valid and enforceable liquidated-damages provisions are those intended by the parties to give reasonable compensation for damages, but provisions that impose amounts that are ‘manifestly inequitable and unrealistic’ are deemed unenforceable penalties.”  Slip Op. at ¶ 19 (citing Sampson Sales, Inc. v. Honeywell, Inc., 12 Ohio St.3d 27, 28 465 N.E.3d 392 (1984)).  It then holds that the precedent requires a “prospective or ‘front end’ analysis” of the liquidated damages provision to determine its reasonableness at the time the contract was executed, and does not permit a retrospective analysis that looks at its reasonableness as applied at the time of the breach. Id. at ¶ 36.  The majority concludes that the $700 per diem charge was not unreasonable on the front end and only appears unreasonable on the back end because Boone’s delay in completing the project was so egregious. Id. at ¶ 38.

The decision deserves a closer look not only by those in the public works industry, but also by all sellers and purchasers of goods and services where time is of the essence. While existing precedent contemplated a prospective analysis to determine the reasonableness of liquidated damages provisions, the Court had not expressly foreclosed looking at the equities at the time of the breach, as it has now done in Boone.  Boone is a particularly chilling precedent because the reason most often cited for enforcing liquidated damages is that the contracting parties have “equality of opportunity” to negotiate the terms and are in the best position to ascertain the “just compensation” for any anticipated failure of performance. Id. at ¶ 14, 39.  Boone had no real opportunity to negotiate the per diem charge and there was no demonstrated relationship between the amount of the liquidated damages assessed and any actual loss or injury caused by the delay in installing the traffic light.  The back-door for any equitable analysis seems to be firmly closed.  A self-help remedy to the specific Boone dilemma may be to couple any proposed per diem liquidated damages provision with an exculpatory clause limiting the aggregate amount of damages that may be assessed.