Published on:

When is a contract provision a liquidated damages clause, and when is a liquidated damages clause an unenforceable penalty?

Two recent court of appeals cases address the enforceability of liquidated damages clauses:  TEC Olmos, LLC v. ConocoPhillips Company, and Fairfield Industries v. EP Energy E&P Company. The Texas Supreme Court requested the parties in TEC Olmos to file briefs on the merits but recently denied review. In EP Energy, the court denied EP’s petition for review, but EP has filed a forceful motion for rehearing and the court has requested a response. In the meantime, the case has been stayed because of EP Energy’s bankruptcy.

A liquidated damages clause is a provision in a contract specifying a dollar amount (“liquidated damages”) to be paid by a party if the party breaches the contract. Such clauses are common in all types of contracts, particularly in the oil and gas industry. If a contractor promises to complete construction of a building by an agreed date and fails to do so, the contract may provide for a payment of an agreed amount for each day completion is delayed. If a party promises to drill a well in a lease or farmout agreement, the parties may agree that, if the well is not drilled, the defaulting party will pay an agreed amount as damages. If a lessee promises to keep a ranch gate closed, the parties may agree on a liquidated damages amount for each time the lessee leaves the gate open.

Texas courts have imposed judicial restraints on the enforceability of liquidated damages clauses. In 2014, the Texas Supreme Court summarized these restraints in FPL Energy v. TXU Portfolio Management Co.:

The basic principle underlying contract damages is compensation for losses sustained and no more; thus we will not enforce punitive contractual damages provisions. In Phillips v. Phillips, we acknowledged this principle and restated the two indispensable findings a court must make to enforce contractual damages provisions: (1) “the harm caused by the breach is incapable or difficult of estimation,” and (2) “the amount of liquidated damages called for is a reasonable forecast of just compensation.” We evaluate both prongs of this test from the perspective of the parties at the time of contracting.

In TEC Olmos, ConocoPhillips farmed out acreage to TEC and TEC promised to drill a well; the farmout provided that, if TEC failed to drill, it would pay liquidated damages of $500,000 to ConocoPhillips. The contracted provided:

The Parties acknowledge that the payments set forth in this Article X are [ConocoPhillip}’s sole remedy for [TEC]’s failure to drill and complete (or to plug and abandon as a dry hole, as the case may be) the first Earning Well as provided for in Article III. The Parties acknowledge that actual damages would be difficult to ascertain, the amount of  … Liquidated Damages is reasonable, and that the … Liquidated Damages are not intended to be a penalty.

TEC failed to drill, and ConocoPhillips sued for the liquidated damages. TEC asserted two defenses: its performance was excused by the force majeure clause because the oil price dropped and TEC was unable to obtain its financing; and the liquidated damages clause was an unenforceable penalty. The court of appeals held that both of TEC’s defenses failed as a matter of law.

TEC did not assert that the harm caused by its failure to drill was difficult to estimate. It argued that, because of the oil-price drop, ConocoPhillips suffered no harm by its failure to drill the well, so ConocoPhillips’ return on the well would be “essentially zero.” The court rejected that argument because it failed to evaluate the reasonableness of the liquidated damages at the time of contracting.

EP Energy v. Fairfield Industries was a suit to collect a fee under a seismic data license agreement. Fairfield licensed seismic data to EP. The contract required EP to pay an additional fee if EP assigned the data to a third party or if there was a “change of control” in the ownership of EP. A company purchased EP Energy’s parent company in 2012, resulting in a “change of control” as defined by the license agreement, triggering EP’s obligation to pay the fee (1/2 of the original license fee for the data), which Fairfield claimed to be $21 million. But before the change in EP’s ownership it tendered all of the data back to Fairfield and tried to terminate the license agreement. Fairfield then sued for its fee. The trial court granted summary judgment for Fairfield.

The Houston Court of Appeals (14th District) affirmed. First, it held that EP had no right to terminate the license agreement, and that it could not avoid the fee by returning the data to Fairfield. EP argued that the contract provision imposing a fee was a liquidated damages provision and unenforceable as a penalty because the fee was not a reasonable estimate of actual damages. The court held that the contract provision was not a liquidated damages provision:

Under binding precedent from this court, the fee may be an unenforceable penalty only if it constitutes liquidated damages. In the fee provision the Contracting Parties did not purport to set in advance a liquidated-damages amount to compensate Fairfield for a breach of the Agreement. Effecting a change in control is not a breach of the Agreement.

Our firm recently settled a suit against Chesapeake for additional royalties owed under an oil and gas lease. The lease had two methods for measuring the value of production for purposes of paying royalties: if the lessee sold the production to an unaffiliated purchaser, royalties were based on the gross price received by the lessee; but if the production was sold to an affiliate of lessee, royalties would be based on a much higher price for the production. Chesapeake contended that the royalty clause was a disguised liquidated damages clause and unenforceable as a penalty. Because the lessee had the right to sell its production to an affiliate or not, sale to an affiliate was not couched as a breach of the lease, but only changed the method of valuing production for royalty purposes. If the holding in EP Energy is correct, the royalty clause cannot be a liquidated damages clause.

One can understand EP Energy’s frustration. Taking the liquidated damages clause in ConocoPhillips v. TEC Olmos as an example, that clause could have been written differently. It could have provided that TEC must either drill a well or pay ConocoPhillips $500,000. Failure to drill would not be called a breach of the agreement for which liquidated damages are due, but merely an alternative method of performance. Most if not all liquidated damages provisions could be drafted so as to avoid the scrutiny of the enforceability test set out in FPL Energy.

Another example: a residential lease provides that, if the lessee remains in possession after the end of the lease term, it owes rent of three times the rental during the lease term. Is that a liquidated damages provision, and does it impose an unenforceable penalty?

It may be argued that courts should not place limits on the enforceability of liquidated damages clauses in commercial contracts between sophisticated parties. Except in consumer contracts where there is a vast difference in bargaining power between the contracting parties, parties should be able to agree on the consequences of a breach of their agreement. As the court said in EP Energy, the court “must enforce an unambiguous contract as written. Our role is not to question the wisdom of the parties’ agreement or to rewrite its provisions under the guise of interpreting it.”

We will wait to see if the Supreme Court decides to address the issue.

Posted in:
Published on:

Comments are closed.

Contact Information