Are Liquidated Damages Clauses Enforceable in Texas?

What a liquidated damages clause does

A liquidated damages clause fixes in advance what one party pays if it breaches: a per-day charge for late completion, a flat fee for canceling a service agreement early, a multiple of monthly fees for walking away from a lease or a franchise. The appeal is certainty. Neither side has to prove actual losses after the fact, and the breaching party knows its exposure.

Texas enforces these clauses, but not without limits. Courts will not enforce a provision whose real purpose is to punish breach rather than to compensate for it, because enforcing a penalty violates public policy. The dispute in almost every liquidated damages case is which side of that line the clause falls on.

The Texas test

The Texas Supreme Court set the test in Phillips v. Phillips in 1991 and has applied it since. A liquidated damages clause is enforceable if, at the time the contract was made:

1. the harm caused by the breach was incapable or difficult of estimation, and
2. the amount of liquidated damages called for was a reasonable forecast of just compensation.

Both parts are judged as of signing. The question is whether the parties, when they agreed, faced a loss that was hard to measure and chose a figure that reasonably approximated it, not whether the figure looks right in hindsight.

The 2020 refinement: the second look

In Atrium Medical Center v. Houston Red C in 2020, the court confirmed that Texas courts may take a second look at the clause at the time of breach. A clause that passes the Phillips test on its face can still be struck as a penalty if the actual damages turned out to be so far below the liquidated sum that enforcing it would be an unbridgeable discrepancy between the two. The court used that phrase deliberately: an ordinary difference between forecast and reality does not defeat the clause, and the party resisting enforcement must prove the actual damages that make the gap unbridgeable.

The decision also clarified the burdens. The party seeking to enforce the clause must show it meets the Phillips conditions. The party resisting it carries the burden of proving the penalty defense, including the evidence of actual damages needed for the second look. A defendant who simply argues that the sum is high, without proving what the real loss was, has not met that burden.

What the analysis looks like in practice

Courts applying the test look at the nature of the contract and the loss. Factors that favor enforcement include losses that are inherently hard to price (a delayed opening, reputational harm, the disruption of replacing a key vendor), a figure that bears some relationship to the contract price or to the losses the parties discussed, and a clause that scales with the severity of the breach (per-day, per-unit). Factors that point to a penalty include a single fixed sum payable for any breach regardless of its seriousness, a sum that dwarfs any plausible loss, and a loss that could have been easily measured at signing (unpaid invoices, for example, which are simply a sum of money owed).

Where actual damages are readily calculable, there is little room for liquidated damages. A clause that charges a fixed sum for failing to pay an invoice on time is usually a penalty, because the harm (the unpaid amount plus interest) is easy to measure.

Example

Suppose a Dallas restaurant group signs a five-year contract with a point-of-sale software vendor at a monthly fee, and the contract says that if the customer terminates early it owes the remaining months' fees in full. The group terminates after eighteen months. The vendor sues for the 42 remaining months. The vendor's harm at signing was hard to estimate (it priced the deal assuming five years of revenue and sunk onboarding costs), which favors enforcement. But the clause charges the full remaining revenue without any deduction for the costs the vendor no longer has to incur in serving the account, and the vendor was free to resell the capacity. If the restaurant group pleads the penalty defense and proves the vendor's actual loss was a fraction of the 42 months, the court may find an unbridgeable discrepancy and refuse to enforce the clause, leaving the vendor to prove its actual damages. A clause that charged, say, a declining percentage of remaining fees would have a stronger claim to being a reasonable forecast.

Liquidated damages in common Texas contracts

• Construction. Per-day delay damages are the standard case for enforcement, because the owner's loss from a late project is real and hard to fix in advance. They are addressed in delay claims and liquidated damages on construction projects.
• Commercial leases. Accelerated rent and early termination charges are tested under the same rules, and the landlord's actual ability to relet the space is often the evidence on the second look.
• Service and SaaS agreements. Early termination fees, as in the example above.
• Non-competes and NDAs. Fixed sums for breach of a restrictive covenant are scrutinized closely because the harm, while hard to measure, is also easy to overstate.
• Earnest money. A clause making the earnest money the seller's sole remedy if the buyer defaults is a liquidated damages provision and is generally enforced in commercial real estate deals.

If the clause fails, what then?

The contract does not fail with it. An unenforceable liquidated damages clause is struck, and the injured party may prove and recover its actual damages under the ordinary rules, subject to any other limits in the contract. That outcome is sometimes better for the injured party and sometimes worse, which is why the party resisting the clause should calculate before attacking it. The categories of actual damages and the proof they need are set out in what damages a business can recover for breach of contract in Texas.

A separate question is whether the party enforcing the clause can also recover actual damages for the same breach. Generally not: liquidated damages are a substitute for actual damages on the breach they cover, not an addition. Attorney's fees and other categories outside the clause may still be recoverable.

Drafting and reviewing the clause

The test points to what a defensible clause looks like: it addresses a harm that is hard to quantify, it states a figure the parties can tie to a real estimate at signing, it scales with the seriousness of the breach where possible, and it does not attach the same sum to trivial and serious breaches alike. Recording in the contract why the figure was chosen helps, because the first part of the test is about what the parties faced at signing. A clause that caps liability rather than fixing a sum is a different device and is reviewed under different rules, covered in whether a contract can cap the damages you recover.

Tina Wysk represents Dallas businesses enforcing and resisting liquidated damages provisions in contract litigation and arbitration.