What are liquidated damages?
Why include a liquidated damages clause in a contract?
Is it enforceable in court?
In this article, we will break down the notion of liquidated damages so you know all there is to know about it.
We will talk about the definition of liquidated damages, its benefits, how the court evaluates it from an enforceability perspective, we’ll look at examples and answer frequently asked questions.
Are you ready?
Let’s get started!
What are liquidated damages?
Liquidated damages or liquidated and ascertained damages are amounts that contractual parties agree to pay one another in the event of a breach of contract as a means to compensate actual damages the non-breaching party may potentially suffer.
Liquidated damages definition
Investopedia defines liquidated damages as follows:
“Liquidated damages are presented in certain legal contracts as an estimate of otherwise intangible or hard-to-define losses to one of the parties. It is a provision that allows for the payment of a specified sum should one of the parties be in breach of contract.”
What’s important with this definition are the following elements:
- Intangible or hard-to-define losses
- Breach of contract
In essence, the parties attempt to contractually quantify and estimate actual damages a non-breaching party may suffer due to certain events of default happening.
Law.jrank.org reports that the American Law Reports defines liquidated damages as follows:
“Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in light of the anticipated or actual harm caused by the breach. … A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty”
Under this definition, we can also see the reference to the reasonableness of the liquidated damages in light of the actual damages or harm suffered.
Purpose of liquidated damages
The liquidated damages are correlated with the actual damage a party may suffer in the event the other party breaches the terms of the contract.
For example, a party will estimate how much he or she stands to lose per day if the delivery of the project is delayed and factors the cost into the liquidated damages.
In a construction contract, a party may estimate that for every day of delayed delivery, it may suffer damages of $500 per day.
As a result, they’ll define liquidated damages of $750 per day should a party be late in delivering the work on time.
Liquidated damages clause
A party cannot invoke liquidated damages unless the contract expressly provides for a liquidated damages provision.
Liquidated damages must be properly scoped and defined in a contractual clause.
What makes a liquidated damages clause attractive is that the parties contractually estimate damages in the event the other party fails at certain obligations or due to certain events.
Should the contractually defined event of default occur or specific contractual terms are breached, the beneficiary of the liquidated damages can claim the damages without having to prove actual damages.
Why include a liquidated damages clause?
There are a few important reasons why parties include a liquidated damages clause in their contract.
Let’s look at a few of them.
Proof of actual damages is difficult
Including a liquidated damages clause can be useful in instances when actual damages can be difficult to prove.
A contractual party can claim the liquidated damages provided for in a contract without having to provide evidence of the actual damages.
The caveat is that the liquidated damages must represent a fair estimate of the non-breaching party’s actual damages.
In other words, the liquidated damages amount should compensate for the actual loss suffered rather than punitive damages.
If the amount is unreasonable or appears to be punitive in nature, the courts may not enforce the liquidated damages clause.
Better evaluation of risk
If negotiated properly, liquidated damages can be beneficial for both the breaching party and the non-breaching party.
The breaching party will have the comfort to know that a particular event can trigger the liquidated damages clause and the damages are fairly set in advance.
It is much easier to evaluate potential risk and liability.
On the flip side, the beneficiary of liquidated damages will have the comfort to know that the other party will compensate him or her for failure to properly execute the terms of the contract without having to incur important costs and fees proving actual damages in court.
Are liquidated damages enforceable?
In the United States, most states have laws and statutes governing the treatment of liquidated damages in a contract.
In some states, the law requires that the liquidated damages be drafted in a specific way while in other states the law requires the liquidated damages to be reasonable.
The reality is that enforcing a liquidated damages provision in court may not be that easy.
Legal conditions to be met
In common law, for liquidated damages to be upheld, you’ll generally need to demonstrate two conditions:
- The liquidated damages should be a fair estimation of the actual damages a non-breaching party may suffer to the contractual breach
- The actual damages should be sufficiently certain at the moment of signing of the contract
If the damages are uncertain or hypothetical at the moment of signing, the court may not enforce the liquidated damages clause.
In addition to that, if the liquidated damages do not represent a fair and good proxy of actual damages, the court may not enforce it.
Court’s overall assessment
The courts will analyze the circumstances of the contractual breach, the actual damages suffered, the reasonableness of the contract and so to assess its enforceability.
Generally, the courts will consider the following aspects:
- What was the actual damage suffered by the non-breaching party?
- How were the liquidated damages estimated?
- Is the estimated amount reasonable in the circumstances?
- Is the amount estimated an actual evaluation of compensation or a penalty of some sort?
- Do the liquidated damages represent an exclusive remedy for the breach?
Depending on the court’s overall evaluation of the circumstances of the contractual breach, the liquidated damages provision may be enforced or not.
Bargaining power of the parties
In evaluating the enforceability of a liquidated damages clause, the court will most certainly look at the bargaining power of the parties.
When the contracting parties are of equal power and sophistication, the courts will have less of a concern enforcing a liquidated damages clause provided the objective remains compensatory and not punitive.
On the other hand, if a party was forced to enter into a contract of adhesion or the parties are disproportionate in their level of expertise and power, the courts will consider the likely harm of enforcing liquidated damages clause against the most vulnerable party.
Benefits of liquidated damages clause
An important benefit of including a liquidated damages clause in your contract is with respect to the element of predictability.
Benefits for the payor
In other words, the contracting parties have a clear understanding of what may be the potential cost or damages in the event of a breach.
What’s more, the liquidated damages quantum or amount was duly negotiated by both parties and can be considered a more reasonable and fair assessment of the damages.
For instance, if a contractor fails to deliver a project, he or she will know that for every day of delay, the cost will be $250 or $500.
The damages are predictable.
Without a liquidated damages clause, a party can claim an unpredictable amount of damages.
Benefits for the beneficiary
The beneficiary of the liquidated damages will also see important benefits.
The liquidated damages provision will serve as a reassurance that the other party is serious about getting the job done.
If the job is not done or there’s a breach, the beneficiary of liquidated damages can invoke the same without having to prove actual damages.
It’s sort of like an insurance policy against the breach of the other party.
Liquidated damages calculation
The calculation of liquidated damages is important from an enforceability perspective.
The beneficiary of the damages must be able to demonstrate that the liquidated damages are:
- A fair assessment of actual damages
- The assessment is reasonable in the circumstances
- The amounts are not exorbitant
- The amounts are not disproportional to the actual damages suffered
To that effect, the calculation of liquidated damages is in light of the non-breaching party’s actual damages.
For example, if a company calculates liquidated damages as a multiplier of its gross revenue when the breaching party’s role affected a minor aspect of the company’s operations, the court may not enforce this clause.
There is no right or wrong way of calculating liquidated damages.
What’s important is that the amount should not be seen as punitive, a penalty or a fine.
The purpose of the liquidated damages is to compensate the non-breaching party for a genuine and real loss due to the breach of the other party.
Liquidated damages example
Liquidated damages are a way for parties to estimate actual damages a non-breaching party may suffer due to the breach of the other.
Trade secret infringement
A good example of when liquidated damages may be useful is in the context of software development and the technology industry.
Quite often, in the technology space, companies keep their valuable assets as a trade secret.
In other words, a software company may not copyright their software source code or file for patents and so on.
If a person breaches a software company’s trade secret, that can cause significant damages to the software company but the actual amount may be difficult to prove.
In this context, a liquidated damages clause can serve as an estimate of a software company’s actual damages should a contractual party infringes its trade secrets.
Breach of confidentiality obligations
A company may suffer damages due to a party’s breach of confidentiality obligations.
For example, if a company is working on a brand new innovative product, the design, the specifications, the studies and market research behind the scene represent highly valuable and sensitive information for a company.
If a supplier or a designer working on the project fails to protect the confidentiality of the information, the company may suffer damages due to the information falling in the hands of competitors and the market.
A liquidated damages clause can be useful in quantifying a company’s damages otherwise hard to establish due to another party’s failure.
Real estate transactions
Quite often, liquidated damages clauses can be found in real estate transactions where the specific amount of a potential actual damage may be hard to determine.
For example, imagine a party intends to purchase another’s real estate property for $300,000.
The offering party can make a purchase offer and deposit an amount of $10,000 to demonstrate his or her seriousness.
However, if the offering party backs out of the transaction, the $10,000 will be paid to the seller as liquidated damages to compensate for the failure to pursue the transaction.
The seller will not need to prove that he or she actually lost $10,000 as the parties had agreed to the deposit to represent the seller’s liquidated damages should the buyer back out.
Frequently asked questions
What is the difference between liquidated damages and penalty?
Liquidated damages represent a fair and reasonable estimate of damages a party may suffer due to the contractual breach of another party.
The aim of liquidated damages is to compensate a party for actual damages suffered.
The key term here is “compensate”.
On the other hand, a penalty clause or a penalty is intended to punish a contractual party for certain acts or omissions.
The nature of a penalty clause is to go over and above the compensation of actual damages but the punish the breaching party for their failure.
If liquidated damages are viewed as punitive in nature, the courts will not enforce it.
Can you recover liquidated damages and actual damages?
No, you can’t.
A party should either claim actual damages or liquidated damages intended to estimate hard-to-define but “actual” damages.
A party invoking both liquidated damages and actual damages is essentially double-dipping.
The purpose of liquidated damages is to compensate a party for potential but actual damages that may be difficult to prove or establish.
Going for actual damages or liquidated damages may be a strategic decision but they cannot be claimed cumulatively.
What are unliquidated damages?
Unliquidated damages are damages that are not sufficiently certain.
Unliquidated damages could be difficult to calculate mathematically or can even be subject to a contingency.
When damages are said to be unliquidated, they are pretty much non-calculable.