Liquidated damages may not impose a penalty

In Carroll v. REO, LLC, a real estate agent sued her former brokerage, arguing that the liquidated damages term in her independent contractor agreement was an unenforceable penalty. Upon the agent’s termination, the commission was split 50/50 for pending transactions closing after termination (after the 5% Broker Fee). The district court ruled in the agent’s favor.  The brokerage, REO LLC d/b/a RE/MAX, appealed.  On July 27, 2016, the Iowa Court of Appeals affirmed.

Iowa law allows liquidated damages by contract, so long as those damages do not constitute a penalty. Damages for breach may be liquidated in the agreement, but only at an amount that is reasonable in the light of: (1) the anticipated or actual loss caused by the breach; and (2) the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy.

The Iowa Supreme Court uses a two-factor test to determine if a liquidated damages term is enforceable.  The first factor is the anticipated or actual loss caused by the breach. The amount fixed is reasonable, if it approximates either the actual loss that resulted from the breach, or if it approximates the loss anticipated at the time the contract was made. The second factor is the difficulty of proof of loss. The greater the difficulty either of proving loss, or of establishing the amount of loss, the easier it is to show that the amount fixed is reasonable.

RE/MAX first claimed that the district court improperly placed the burden on RE/MAX to demonstrate the liquidated damages clause was not a penalty. Under Iowa law, the agent was required to prove that the liquidated sum was unreasonable. After listing the nine factors upon which the district court relied, the Court of Appeals held that the district court did not impose an impermissible burden on RE/MAX.

RE/MAX next argued the district court erred in comparing the liquidated damages to actual losses, rather than to the anticipated loss at the time of the contract. However, the trial court held, and the Court of Appeals agreed, the record contained insufficient evidence to establish what the anticipated or actual losses would be. Both the trial court and the Court of Appeals repeatedly noted the lack of evidence demonstrating why the 50/50 split was imposed. In light of this deficiency, the Court of Appeals found no error.

Finally, RE/MAX contended the district court erred in determining the liquidation damages clause was a penalty. The appeals court first addressed whether the amount of actual damages resulting from a breach was uncertain. The Court of Appeals considered RE/MAX’s arguments as to the efforts undertaken to collect information missing upon the agent’s termination, and to assign new agents to listings, but the court pointed out that most work was done by the brokerage owners, not other agents. Thus, the record did not demonstrate that damages were so uncertain that a liquidated damage clause was needed.

As for determining whether the amount of liquidated damages under the clause was reasonable, the district court concluded, “[t]he record is insufficient to establish that the 50% commission rate is a reasonable rate since the record contains insufficient evidence to establish what the anticipated or actual losses would be.” The appellate court then went through each of RE/MAX’s justifications for the reasonableness of the damages provision, and discounted the reasoning, concluding, “There is no indication what amount of losses RE/MAX actually sustained and no explanation why the 50/50 split reasonably portrayed the anticipated or actual losses.” Thus, the unexplained increase from RE/MAX’s entitlement to 5% of the commission to 52.5% of the commissions was unenforceable.

For parties seeking to include liquidated damages in their agreements, Carroll v. REO, LLC is a valuable tool. Any party intending to include a liquidated damages clause in an agreement should go through a rigorous, objective analysis under Carroll v. REO, LLC, to ensure that the provision will withstand future scrutiny. For additional information regarding Carroll v. REO, LLC or other topics of commercial litigation, contact Mollie Pawlosky.

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.

- Mollie Pawlosky