title
header

News / Articles / Blog

March 6, 2000

New Jersey Law Journal

Vol. CLIX – No. 10 INDEX 972

Maurice W. McLaughlin

Liquidated Damages in Employment Contracts

We live in a nation of employees.  In New Jersey, as in the majority of states, most employment relationships are "at will."  At will employees may be terminated for a good reason, a bad reason, or no reason at all, provided that they are not terminated for a discriminatory reason, such as race or gender.  Witkowski v. Thomas J. Lipton, Inc., 136 N.J. 385, 397-398 (1994). 

Employers and employees may contractually define the terms of their relationship beyond the scope of employment at will.  If the agreement satisfies the elements of a valid contract, the parties will then be bound by this agreement.  Id., at 398. 

Potential breaches are often contemplated when drafting employment contracts.  Parties often understandably desire to avoid the expense and uncertainty of litigation.  One common method is the provision for “liquidated damages” in the event of a breach.

Liquidated damages are The sums a party to a contract agrees to pay if he or she breaks some promise.  The amount is calculated by a good faith effort to estimate in advance the actual damages that will probably ensue from the breach, and is legally recoverable as agreed damages if the breach occurs.  

Liquidated damages allow parties to control their exposure to risk; avoid the uncertainty, delay and expense of litigation; and promote economic efficiency.  Consistent with a general trend toward enforcing such clauses, liquidated damages are presumptively enforceable.  The party challenging a liquidated damages clause has the burden of proving that it is unreasonable.  Wasserman’s Inc. v. Township of Middletown, 137 N.J. 238, 248-252 (1994).

Because only actual, compensatory damages can be recovered for breach of contract, liquidated damages clauses must be designed to reasonably forecast the damages resulting from a breach.  "A [contractual] term fixing unreasonably large liquidated damages is unenforceable on the grounds of public policy."  Wasserman’s, 137 N.J. at 248-249; Nohe v. Roblyn Construction Co., 296 N.J. Super. 172, 177 (App. Div. 1997).

The standard used to determine the validity of a contractual damages provisions, a question of law, is well established.  To be valid: 

  1. The provision must be a "reasonable forecast of just compensation" for the harm caused by the prospective breach. 
  2. This harm must be impossible or difficult to calculate. 

If either of these elements is not satisfied the provision is an unenforceable penalty.  "If it is doubtful whether the provision for payment is intended as a penalty or liquidated damages, it will be construed as a penalty, because the law favors more indemnity." Wasserman's, 137 N.J. at 250-251, 257; Westmount, 82 N.J. Super. at 206. 

If the provision sets "unreasonably large liquidated damages," it is a penalty and "unenforceable on grounds of public policy."  The logic behind this is simple-liquidated damages must estimate actual damages because they must be compensatory in nature.  Following this reasoning, penalties, which seek to punish the breaching party, are invalid because they are punitive in nature.  See Wasserman’s, 137 N.J. at 248-252, 257; Nohe, 296 N.J. Super. at 177. 

Determining the Damages

Damages may be calculated at the time the contract was made or at the time of the breach.  In Nohe the party invoking liquidated damages demonstrated no damages except the inconvenience and expense of finding a new real estate buyer. 

The Appellate Division, however, considered these to be no damages and found that $79,027.40 was a substantial sum.  The provision was therefore a void and unenforceable penalty.  Nohe, 296 N.J. Super. at 174-179; Westmount, 137 N.J. at 251.  

The following example applies this test to the employment context.  Assume that an employee is an upper level executive for a large oil company (Oil Inc).  The executive has an employment contract which contains a “no-raiding” provision (restrictive covenant) prohibiting him from hiring or soliciting Oil’s employees should he leave his position with the company. 

The contract provides that breach of the restrictive covenant will cause the immediate termination of Executive’s unexecuted options in Oil stock, worth $9 million.  Executive leaves Oil and takes a high level executive position with a technology firm called Chip.com.  Shortly after joining Chip.com, he solicits and hires his brother-in-law -- then working for oil -- to a position with Chip.com, clearly violating the restrictive covenant. 

Assume that brother-in-law was an unskilled laborer, and that Oil had to expend no time, funds or effort to replace him.  Clearly, then, Oil has not been damaged, but seek to recover $9 million in liquidated damages from Executive. 

In this case, regardless of when Oil’s alleged damages -- if any -- are measured, they bear no relationship to the penalty imposed.  The damages provision thus serves only to punish or deter a breach.  The damages provisions are thus penalties and therefore void.

Forecasting the Harm

Liquidated damages that are "unreasonably large" are unenforceable if they do not reasonably forecast harm caused by a breach.  To reasonably forecast these alleged damages the purported liquidated damages need to accurately forecast:  (1) The prospective harm to defendant; and (2) the penalty imposed on plaintiff.  In this example they do neither. 

The damages provisions Oil seeks to invoke make no attempt to forecast the prospective harm resulting from a prospective breach measured when the contract was made.  That is because it would not yet be known who would be solicited or whether the solicitation would be successful. 
Damages for both successful and unsuccessful solicitation of corporate employees at different levels, however, would be relatively simple to forecast.  Using such means, for example, as recruiting costs, training costs, retention incentives such as increased pay, or like measures.  A simple sliding scale could provide a different damage ratio depending on the employee's level and success of the solicitation. 

Assume that plaintiff successfully solicited brother-in-law, who was either Oil’s chief executive officer, a janitor, a rig foreman or somewhere between.  The loss of these different levels of employee would entail far different damages, probably by millions of dollars.  The damages provisions, however, make no provision for the varying damages which would result, whenever measured.

Alternatively, assume these employees decided to stay with Oil without incentives or inducements.  Clearly, then, there would be no relationship between the liquidated damages and the actual or contemplated harm.  

Likewise, the very nature of the penalties imposed demonstrates that the damages provisions could not accurately estimate their impact on Executive.  The value of options fluctuate wildly and thus could thus not accurately calculate the cost to Executive (or Oil’s harm).  If the company intended to invoke these provisions only for loss of a high level executive the damages provision might arguably be enforceable.  This should be explicitly provided for in the contract, however, or it leaves the contract open to the interpretation that it would be enforced for loss of any employee. 

Where damages provisions do not differentiate between the level of employee or success of the solicitation, do not account for the harm to the employer or lack thereof, do not consider the cost to plaintiff, then the amounts recoverable are unreasonably large and bear no relationship to any prospective harm.  They are thus penalties that are void and unenforceable as a matter of law and public policy, whenever measured.  Nohe, 296 N.J. Super. at 176-179; Wasserman's, 137 N.J. at 250-251, 257; Westmount, 82 N.J. Super. at 206. 

Calculability of the Harm Caused by Prospective or
Actual Breach

The other required element is that the expected harm must be difficult or impossible to calculate.  However, “uncertainty or difficulty in assessing damages is... not an independent test."  It is "an element of assessing the reasonableness" of a provision for stipulated damages.  Thus, a provision for stipulated damages may be difficult or impossible to determine, and yet still be unreasonable.  Wasserman's, 137 N.J. at 250.

In our example, any damages that may have resulted from brother-in-law’s departure could perhaps be calculable.  Profits and losses could easily be determined using the tax returns.  The analysis of Oil’s efficiency or productivity could be used.  The actions to retain brother-in-law or hire or search for a replacement to mitigate the company’s damages could also be utilized, especially if this is industry practice.

However, even if determining the exact figure of monetary harm was difficult to determine, it is not reasonable to impose $9 million in damages for loss of a low or mid-level employee.  This is amplified by the fact that the executive’s employment contract fails to provide that the liquidated damages will not be invoked for unsuccessful solicitation.  Thus, even if the harm resulting from the departure of a janitor -- or even a rig foreman or mid-level executive –was difficult to determine, $9 million is an unreasonable amount of damages. 

Courts will not examine whether or not Oil intended to enforce the contract for loss or unsuccessful solicitation of a low level employee to determine its reasonableness.  “Even those courts [in other jurisdictions which review the intentions of the parties] recognize that subjective intent has little bearing on whether the clause is objectively reasonable." Wasserman's, 137 N.J. at 250-251. 

The bargaining positions of employer and employee are inherently unequal, subjecting employment contracts to stricter scrutiny than the normal contract.  Ingersoll-Rand Co. v. Ciavatta, 216 N.J. Super., 677, 671 (App. Div. 1987).  Low or mid-level employees, and in most cases upper level executives, cannot hope to match the bargaining power of today’s large corporations.  Courts therefore will not review the purported intent of the parties.

Contracts of Adhesion

The presence of unusually large liquidated damages may indicate that the employment agreement is a contract of adhesion.  If it is, neither the liquidated damages provisions nor the contract itself will be enforced.

There is inherent inequality in the bargaining positions of an employer and employee, with the employer holding the more advantageous position.  New Jersey Courts, therefore, subject employment contracts to stricter scrutiny than general commercial contracts.  Ingersoll-Rand, 216 N.J. Super. at 671.  Factors which the Court must evaluate to determine whether a contract is one of adhesion are: 

  1. The subject matter of the contract;
  2. The parties' relative bargaining positions; and
  3. The degree of economic compulsion motivating the adhering party.

A review of these factors shows that the agreements are contracts of adhesion.  Rudbart v. No. Jersey Dist. Water Supply Comm'n, 127 N.J. 344, 353, 355-356, cert denied, sub nom., 506 U.S. 871 (1992). 

This review will be undertaken in light of the stricter scrutiny given to employment contracts because of the inherent inequality of the parties’ bargaining positions. 

An employment agreement deals with employment security, which New Jersey's Supreme Court has recognized as an important subject. See Nicosia v. Wakefern Food Corp., 136 N.J. 401, 419 (1994) ("We recognized the importance of employment security....We are a nation of employees").

Employers and employees occupy inherently unequal bargaining positions.  Ingersoll-Rand, 216 N.J. Super. at 671.  Under all but the most unusual circumstances, the employer will have far greater resources than the employee.  The parties will therefore normally have unequal bargaining power.

"The central nature of a contract of adhesion is that it is presented on a take-it-or-leave-it basis... without opportunity for the 'adhering' party to negotiate except perhaps for a few particulars."  Rudbart, 127 N.J. at 353.  Thus, if the employer presents the employment contract as a “take-it-or-leave-it” proposition, it will be a contract of adhesion.  Representation will not change the nature of a contract of adhesion if it meets all the other elements.  Leonard & Butler, 279 N.J. Super. at 670-671. 

Thus, where an employment agreement is presented by employer to employee as a "take-it-or-leave-it" proposition, the subject matter is employment or employment security, the parties' relative bargaining positions are unequal, and economic compulsion is exerted on the employee, the employment agreement is unenforceable and a contract of adhesion.

Employers’ Duty to Mitigate Its Damages

Assuming for the sake of argument that Oil Inc. suffered $9 million in damages, the company must still meet its duty to mitigate its damages.

When one party breaches a contract, the non-breaching party has an absolute duty to mitigate its damages.  It must make "affirmative" actions to lessen its damages.  Recovery is not allowed to the extent that the damages could have been avoided. Ingraham v. Trowbridge Builders, 297 N.J. Super. 72, 82-83 (App. Div. 1997).  This duty is unaffected by provisions for stipulated damages. Wasserman's, 137 N.J. at 258.

Phrasing a liquidated damages provision as a “forfeiture,” does not remove it from the foregoing analysis.  Nohe v. Roblyn Construction Co., the most recent New Jersey Appellate Division Opinion on penalties, clearly holds that even where a damages provision can be construed as a forfeiture, it would nonetheless be an invalid penalty.  Courts will "refuse enforcement of the forfeiture if it would result in a large windfall." Nohe, 296 N.J. Super. at 177.

Although New Jersey Courts have not addressed this issue in an employment contract, other state and federal courts have held that termination of payments may be both liquidated damages and penalties. See DJ Manufacturing Corp. v. United States, 86 F.3d 1130 (Fed. Cir. 1996); Space Master International, Inc. v. City of Worcester, 940 F.2d 16 (1st Cir. 1991); Rohlin Const. Co., Inc. v. City of Hinton, 476 N.W.2d 78, 79, 80-81 (Iowa 1991). 

Significantly, the New Hampshire Supreme Court squarely held that a separation agreement providing that upon breach the employee would "forfeit all existing and future rights to remuneration hereunder whether direct or indirect, including but not limited to commissions earned but not yet paid, and any so-called fringe benefits, including severance payments" was both a liquidated damages provision and a penalty. Technical Aid Corp. v. Allen, 591 A.2d 262, 274-276 (N.H. 1991).

The key element with all these cases, as in the New Jersey cases, was reasonableness and proportionality rather than the nature or language of the provision.  Thus content rather than the words used to describe the provision determines whether it is a penalty. Nohe, 296 N.J. Super. 172.  

At least one trial court has ruled otherwise, however.  See Combined Ins. Co. of America v. Hansen, 756 F. Supp. 458 (D. Ore.)  This case, however, is against the weight of both New Jersey, federal and foreign decisions.  These courts including New Jersey’s Appellate Division, had the Combined Ins. Co. opinion available but found it unpersuasive.

As our Supreme Court has stated, "Equity abhors a forfeiture." Dunkin' Donuts of America, Inc. v. Middletown Donut Corp., 100 N.J. 166, 183-184 (1985).  Courts therefore "invoke [their] inherent equitable powers to avoid a forfeiture.” Brinkley v. Western World, Inc., 275 N.J. Super. 605, 610-611 (Ch. Div. 1994), aff'd, 292 N.J. Super. 134 (App. Div. 1996).

Conclusion

What does all this mean for employers?  First, when drafting liquidated damages provisions in employment or separation contracts, the best possible attempt should be made to determine what the anticipated harm is, value the anticipated damages, and use this figure to set the liquidated damages. 

Second, negotiate with the employee.  An “agreement” which the employer forces on the employee is not a valid contract, but rather an unenforceable contract of adhesion. 

Finally, after the employee has breached the agreement, the employer should make reasonable attempts to mitigate its damages.

The employee, however, is in a less advantageous position.  The best that he or she may do is bargain for the best terms possible.  If the employer forces the employee to accept unreasonably large liquidated damages, however, the law provides a remedy. 

 

back to News / Articles / Blogback to top