Contractually-Provided Damages Not Enforceable if They are Mere Penalties

On April 11, 2014, Justice Sherwood of the New York County Commercial Division issued a decision in Maina v. Rapid Funding NYC, 2014 NY Slip Op. 30952(U), refusing to award damages provided by contract on the ground that they were penalties.

In Maina, the court found that the plaintiff had breached its contract with the defendant-counterclaimant. The court refused to grant the defendant all of the elements of damages provided in the parties' agreement, explaining:

Defendants have established a prima facie case for summary judgment, at least as to liability. . . . As to damages, [the defendant] does not adequately explain its entitlement to the purported origination fees that it claims are customary in the industry. These fees are not reflected in the loan agreements, although checks in amounts claimed as origination fees are endorsed on the back by plaintiff as approved. Further, [the defendant] has not shown that the pre-payment fees charged on loans it refinanced are anything other than a penalty. New York condemns the contractural imposition of a penalty. Summary judgement will be granted as to liability.

Regarding defendant['s] claim for an award of attorneys' fees, the Note provides that [the defendant] is entitled to recover attorney fees and expenses in connection with enforcement of any of its remedies equal to 20% of the outstanding principal and interest then due. [The defendant] is entitled to recover attorney fees of 20% only if it demonstrates that the quality and quantity of the legal services rendered were such to warrant, on a quantum meruit basis, that full percentage. Because [the defendant] has offered no evidence to support the reasonableness of the attorneys' fees it seeks, this aspect of the motion must be denied. Moreover, where contractural attorneys' fees are in the nature of a penalty, they should be disallowed. In this case, [the defendant] has imposed multiple contractural penalties on plaintiff. They include large origination fees, late payment penalties, and pre-payment penalties on loans refinanced by [the defendant]. Arbitrary imposition of a 20% attorney fee charge without any need to show that such fees are reasonable, is yet another penalty.

(Internal quotations and citations omitted) (emphasis added).

It is understandable that transactional counsel want to provide a contractual mechanism for ensuring that all of the damages flowing from a breach of contract are recovered by the non-breaching party. However, if that mechanism crosses the line to becoming a penalty, it will not be enforced at all, making it important that contract terms stay on the right side of the line.