Source: Robin Roth, Senior Contracts Editor, Conferon, Inc.
E-Specs: February 3, 2003

Did you ever wonder why contract terms for damages usually state "agreed to constitute liquidated damages, not a penalty"? The liquidated damages part means that damages have been agreed to in the contract ahead of time in case of a breach, which avoids a court battle after the fact, but why add "not a penalty"? The reason is that the law in this country does not allow for penalties in contracts. If there is a breach, the remedy for the non-breaching party is to be "made whole" again. In a case where the group cancels a hotel contract, the hotel is entitled to be made whole by recouping its lost profits from the group. The hotel is not entitled to recoup full lost revenue because that would normally (except in the case of a cancellation less than one week before a meeting) constitute a penalty to the group since the hotel would stand to make more from the cancellation than it would if the meeting had been held as contracted. Part of the legal requirement for liquidated damages is that the parties agree that the terms do not constitute a penalty. A clause that is interpreted to be a penalty could be thrown out in the case of litigation or arbitration.

Another interesting point about this issue is that if motive is brought into the terms, it could trigger the penalty problem. Let’s say for example that you have a sliding scale cancellation clause based on room revenue that goes from 20% due outside of 730 days to 100% due within 90 days. And let’s say that it also states that if the group cancels because it is using another hotel, it will be liable for 100% of the anticipated room revenue, regardless of the date of cancellation. That could constitute a penalty because motive should not increase the damages due. Whatever the reason, the cancellation damages should be the same. The hotel anticipated its actual damages proportionately according to the scale and to ask for 100% across the board for a specific reason is asking for more than its actual damages, therefore a penalty.

It is important that your damages clauses be carefully reviewed to ensure that the amounts agreed upon do not constitute a penalty under the law and that a penalty is not brought into the clause through motive.

(Note: This information is not intended to be "legal advice." A qualified attorney should be consulted to review all contract issues.)