By Ambi Biggs

The parties have finally settled their dispute and agreed-upon terms for a settlement. All that’s left to do is draft the settlement agreement.

Often thought of as a formality that should take minimal effort and expense to prepare, the drafting of the settlement agreement can quickly turn into a “devil in the details” scenario. One or more of the parties to the settlement agreement will often want a provision that prevents the other party from disparaging it or disclosing the terms of the settlement to any third parties. In order to give a non-disparagement or non-disclosure provision some teeth, a party may want to establish an amount that the other party would have to pay in the event of a breach of the provision. However, drafting a liquidated damages provision that will be enforceable can be tricky.

A liquidated damages clause has three primary characteristics: (1) clear and unambiguous language providing for a certain sum to be paid in the event of a breach; (2) the sum must represent reasonable compensation for the damages anticipated from the breach, measured prospectively at the time of the contract formation rather than after the fact at the time of the breach; and (3) a mandatory binding agreement before the fact which may not be altered to correspond to actual damages determined after the fact.

Parties may favor liquidated damages provisions because they provide a set amount that will be awarded in the event of a breach, without the non-breaching party having to prove the amount of damages it has incurred as a result of the breach. This is particularly helpful when the amount of damages cannot be easily ascertained.

However, a court can hold a liquidated damages provision to be unenforceable if it considers the amount of damages provided in it to be a penalty. This can occur when the liquidated damages amount is more than the amount of damages that reasonably could be expected to result from a breach at the time of contract formation.

If the set amount in the liquidated damages provision is too large, the parties risk having a court hold the provision unenforceable. In such an event, the party that wants to enforce the provision would be left to prove its actual damages, which defeats the purpose of having a liquidated damages provision at all (which is to prevent the party from having to prove an amount of damages that is difficult to ascertain).

Instead of including a liquidated damages provision that may later be held to be unenforceable, parties should instead consider including a stipulated damages provision in their settlement agreement. Such an agreement may not be subject to the same analysis of whether the damages amount to a penalty.

The settlement agreement set forth in Smelkinson Sysco v. Harrell, 162 Md.App. 437 (2005) provides a model for an enforceable stipulated damages provision. In that case, a former employee agreed not to disparage his former employer and not to assist any third party in pursuing claims against the company. Importantly, he agreed that if he breached the provision the company was entitled to recover damages flowing from the breach, including but not limited to the amount he received in settlement of his claims. He further agreed that those non-exclusive damages “are not a penalty but are fair and reasonable in light of the difficulty of proving prejudice” to his former employer in the event of a breach.

The employee breached the provision, and the employer sued. The Maryland Court of Special Appeals held that the clause was not a liquidated damages provision because it did not limit the amount of damages to a certain sum, nor did it create a binding agreement that could not be altered to correspond to actual damages. The court held that the provision represented the parties’ arm-length agreement that the employer would not be required to prove damages, and that the amount of damages would be at least as much as the settlement payment. The court held that the agreement was both reasonable and enforceable.

In summary, the keys to drafting an enforceable stipulated damages provision are to include language that: (1) demonstrates both parties agreed to a stipulated remedy in the event of a breach; (2) states that the provision is substantial and material provision of the settlement agreement and inducement for the parties to enter the agreement; (3) establishes that damages are not limited to the amount set forth in the agreement; and (4) acknowledges that the damages are not a penalty.

About the Author: Ambi Biggs is an associate with PilieroMazza who practices in the areas of litigation and government contracts.  She may be reached at [email protected].