Five Minute Law has obtained a top secret legal memo prepared for Donald Trump’s personal lawyer, Michael Cohen, shortly before the 2016 presidential election. The memo provides valuable lessons on the use of “liquidated damages” clauses in confidentiality agreements and other contracts, e.g. non-competes. The memo also reveals that, unlike the author of the Stormy Daniels settlement agreement, Cohen’s associate writes memos in plain English. Enjoy.
CONFIDENTIAL ATTORNEY WORK PRODUCT MEMORANDUM
TO: Michael Cohen
FROM: Alex Associate
RE: Enforceability of Liquidated Damages Clause
DATE: October 15, 2016
Our client, “David Dennison,” is a public figure concerned with protecting his reputation. An “adult film” star named “Peggy Peterson” claims she had a sexual relationship with Dennison. Peterson has offered to sign a strict confidentiality agreement in exchange for a one-time payment of $130,000.
Dennison says that disclosure of the relationship with Peterson will cause severe damage to his relationship with his third wife. He also fears the damage it will cause to his public reputation and the resulting effect on an upcoming public event of some importance to him. Dennison has also implied that disclosure could be embarrassing for additional unidentified reasons.
Dennison has tasked us with preparing “the greatest non-disclosure agreement you’ve ever seen, with real teeth.” In the event that Peterson violates the agreement by disclosing information about the affair, he wants the ability to “sue the pants off her.”
You have prepared a non-disclosure agreement with a liquidated damages clause, i.e. a provision specifying in advance the amount of damages Dennison gets if Peterson breaks the agreement. The clause states that in the event of a breach by Peterson, Dennison can choose to recover either his actual damages or liquidated damages in the amount of $1 million per violation.
The draft agreement also says that a violation will cause Dennison “irreparable injury,” and that Dennison therefore can get a temporary restraining order or injunction to bar disclosure of information about the alleged affair.
1. Is the $1 million per violation liquidated damages clause enforceable, or will it be considered an unenforceable penalty?
2. Does it make any difference if news of the alleged affair is already public?
3. Does Dennison’s right to elect actual damages or liquidated damages affect enforceability of the liquidated damages clause?
4. Does the liquidated damages clause undermine Dennison’s right to get an injunction to prevent disclosure of the confidential information?
1. The liquidated damages clause is likely enforceable if Dennison can show that $1 million per violation is a reasonable forecast of his actual damages resulting from disclosure of the affair.
2. It may be harder for Dennison to argue that $1 million per violation is a reasonable forecast of actual damages if the affair has already become public information.
3. The fact that Dennison can elect actual damages could support an argument that the liquidated damages clause is an unenforceable penalty.
4. The liquidated damages clause could undermine Dennison’s right to get an injunction because it implies that damages are adequate compensation.
1. Reasonable forecast?
A liquidated damages clause that functions as a “penalty” is unenforceable. This is consistent with the fundamental principle of contract law that the remedy for a breach should put the non-breaching party in the same position as if the breaching party had performed the contract.
Remember, contract law is essentially amoral. Students arrive at law school with quaint moral notions about keeping one’s word, that a covenant is sacred, etc. The goal of the first-year Contracts course is to beat this moral sense out of the students. Contract law is supposed to compensate for actual loss, not punish wrongdoing.
This is why a contractual penalty is unenforceable. Different states formulate the test for liquidated damages differently, but the Texas version is typical. In Texas a liquidated damages clause is enforceable if:
(1) the harm caused by the breach is “incapable or difficult of estimation”;
(2) the amount of liquidated damages is a “reasonable forecast” of just compensation; and
(3) there is not an “unbridgeable discrepancy” between the liquidated damages and actual damages.
Courts have applied this standard to various types of contracts, including non-competes. Sometimes a non-compete will have a liquidated damages clause stating that, because actual damages from the employee competing are difficult to measure, the employer can recover a set amount of liquidated damages.
For example, in Nacogdoches Heart Clinic, P.A. v. Pokala (it’s pronounced “Nak-uh-doach-us”), a doctor agreed to pay liquidated damages of $100,000 per month for each month he violated the non-compete. This amount was based on his earnings while working for the clinic, not the actual loss the clinic expected to suffer if he left. The clause therefore was unenforceable because it was not a reasonable forecast of just compensation. Nacogdoches Heart Clinic, P.A. v. Pokala No. 12-11-00133-CV, 2013 WL 451810, at *7 (Tex. App.—Tyler Feb. 6, 2013, pet. denied) (mem. op.) (citing Phillips v. Phillips).
We can draw two lessons from Nacogdoches Heart Clinic. First, maybe I should have picked medical school over law school. Second, a liquidated damages clause in a non-compete should not be based on the amount the employee earns at the company.
See also The Shops at Legacy (RPAI) L.P. v. Del Frisco’s Grille of Texas, LLC, No. 05-19-01274-CV, 2020 WL 4745548, at *5 (Tex. App.–Dallas Aug. 17, 2020, no pet. h.) (mem. op.), where the court held that a liquidated damages clause in a non-compete clause in a lease functioned as an unenforceable penalty, where it used the same measure of damages regardless of whether the competing business would divert customers from the leased premises, and the landlord offered no evidence it suffered actual damages approximating the $350,000 it claimed under the clause.
Another problem with a liquidated damages clause in a non-compete is that actual damages for breach of a non-compete are usually not that difficult to measure. The typical measure is lost profits. While calculating lost profits is not necessarily easy, it’s not exceedingly difficult either, especially if you hire a good CPA as an expert witness on damages.
Damages for harm to reputation, on the other hand, are more difficult to measure. It won’t be hard for Dennison to argue that damages from Peterson revealing information about the alleged affair are “incapable or difficult of estimation.”
It’s the second prong of the liquidated damages test that will be more of a challenge for Dennison: showing that $1 million per violation is a reasonable forecast of actual damages.
One million per violation does not appear to be a reasonable forecast of the actual damage. It’s almost eight times the amount of consideration Dennison will pay to obtain Peterson’s commitment to non-disclosure. Presumably, $130,000 is a reasonable estimate of what it is worth to Dennison to keep Peterson’s information from becoming public.
2. What if the information is already public?
If information about the alleged affair is already public, it may become more difficult to argue that $1 million per violation is a reasonable forecast of actual damages.
If the public had no inkling about the alleged affair, Dennison could argue that any public disclosure of the information would cause great harm to his reputation.
But what if facts about the alleged affair—including details shared in a 2011 tabloid interview—are already public knowledge? In that case, Dennison would have to make the difficult argument that $1 million is a reasonable forecast of the additional harm to his reputation that the additional disclosure would cause.
And proving additional harm to his reputation would become even more difficult if, hypothetically, it is well known that Dennison has a history of adultery, or if multiple women have accused him of sexual harassment or assault.
3. Election of actual damages
You have advised me that our client likes to have his cake and eat it too. Accordingly, the draft settlement agreement says that if Peterson violates the non-disclosure agreement, Dennison gets to choose between recovering actual damages or liquidated damages.
This is problematic. First, the fact that Dennison can recover actual damages could weaken the argument that actual damages are “incapable or difficult of estimation.” If recovering actual damages is an option, that implies that actual damages can be reasonably calculated, making enforceability of the liquidated damages clause less likely.
To illustrate, one Virginia case said that allowing a party to choose between actual damages and liquidated damages suggested that the liquidated damages clause was an unenforceable penalty.
Second, the ability to elect between actual or liquidated damages could render the agreement “unconscionable.”
Courts generally don’t second-guess whether a contract is fair. In the absence of fraud or duress, private parties are generally free to enter into unfair contracts. But this freedom is not without limits. At some point, a contract provision can be so fundamentally unfair that a court will rule the contract unconscionable and unenforceable.
In this case, a judge or arbitrator might think giving Dennison the right to choose between actual damages and liquidated damages is just too much.
4. Can Dennison have liquidated damages and an injunction too?
Not only does the draft agreement allow Dennison to elect whether to recover actual or liquidated damages, it also expressly gives him the right to get a temporary restraining order or injunction to prevent threatened disclosure of the confidential information, i.e. a “gag order.”
But would the liquidated damages clause undermine Dennison’s ability to get an injunction?
It is typical for a confidentiality agreement to recite that disclosure of the information would cause “irreparable injury” and entitle the non-breaching party to get an injunction. This type of clause is also found in non-competes and other employment-related agreements.
There are essentially three views of these “irreparable injury” clauses:
(1) They have no legal effect whatsoever, because private parties don’t get to tell courts how to decide whether to grant an injunction.
(2) They conclusively establish that the non-breaching party is entitled to an injunction.
(3) They are not dispositive but are a factor to be considered.
Courts tend to sidestep the issue by choosing option (3). So, let’s assume the irreparable injury clause will not necessarily relieve Dennison of the burden of showing that a threatened violation would cause him irreparable harm.
The problem is that the liquidated damages clause weakens the claim of irreparable injury. Irreparable injury means harm that cannot be adequately compensated by damages. But if $1 million is a reasonable forecast of actual damages, that suggests that $1 million is adequate to compensate Dennison.
On the other hand, Dennison could argue that the liquidated damages clause is inadequate if Peterson lacks sufficient assets to satisfy a judgment of $1 million or more.
Perhaps the solution is to add a clause to the agreement allowing Dennison to obtain a confidential ex parte temporary restraining order from an arbitrator without notice to Peterson. This will give Dennison the relief he needs, and no one will ever know.
*Update: You can read what five law professors had to say in this Slate article. They tend to agree that $1 million per violation is not a reasonable forecast of actual damages. They also point out that it is unreasonable to forecast that each violation will cause the same amount of harm, and that the cumulative effect of the clause would be unreasonable—is $20 million a reasonable forecast of the harm of 20 violations?
Zach Wolfe (firstname.lastname@example.org) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Thomson Reuters named him a 2020 Texas “Super Lawyer”® for Business Litigation.
Any opinions expressed are his own, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.