Liquidated damages are specific sums of money or consideration contractually agreed upon by parties to a contract. Basically, if a contract is breached by one party, liquidated damages are owed to the other, injured party (or parties) to the contract.
What is the Purpose of Liquidated Damages?
The main purpose of a liquidated damages provision in a contract is to set a predetermined amount of compensation in situations where the actual damages are difficult to prove or calculate. This can also help reduce any associated legal costs since the amounts are effectively predetermined.
Liquidated Damages Help Provide Assurance in a Dispute
Basically, the breaching party knows its probable loss, and the injured party is assured of some compensation without having to go to court. However, it’s important to note that a liquidated damages provision is not meant to punish the breaching party but is only a reasonable estimate designed to compensate the injured party.
How Do Liquidated Damages Work?
Liquidated damages are amounts of money or consideration that both parties agree upon if a breach of a contract occurs. The liquidated damages provision outlines the damages amount as well as what is considered a contractual breach that triggers the payment of liquidated damages.
If one of the parties breaches the contract, it will pay the liquidated damages to the other, injured party. However, liquidated damages are usually only applicable to contractual agreements, and are different from punitive or actual damages.
When are Liquidated Damages Paid?
In order for liquidated damages to be paid, they must be agreed to in a contract. As part of this agreement, the parties must discuss and agree on a specific formula or mechanism that will calculate the liquidated damages if the contract is breached.
The damages amounts should be considered reasonable by both parties or the liquidated damages provision may not be enforceable. When entering into a contract with a liquidated damages provision, all contractual parties should consult with legal counsel to ensure the provision is both reasonable and enforceable.
There will also be contractual language determining if a contract is breached. If one of the contractual parties fails to meet its obligations, then this may trigger the liquidated damages provision.
The injured party then has the right to claim liquidated damages, potentially without the need to go to court, which can save time and legal costs. This provides a more efficient method of receiving compensation without the need to go through a potentially drawn-out legal process.
Disputing a Liquidated Damages Clause
The breaching party may elect to go to court and dispute the liquidated damages agreement. The breaching party may argue that the liquidated damages are punitive or were incorrectly calculated.
The breaching party may also argue that a breach did not in fact occur. If the court agrees with the breaching party, then it may order the breaching party to pay partial liquidated damages or ask the injured party to prove its actual damages.
Of course, if the breaching party does not contest the liquidated damages clause, then it will pay the amounts owed as outlined in the contract.
Depending on the contract, the liquidated damages clause might not prevent the injured party from seeking other legal remedies, such as specific performance or equitable relief.
Causes and Examples of Liquidated Damages
One common example of liquidated damages occurs when purchasing a house. If a buyer cannot purchase the house by the closing date, then the buyer might have to forfeit any earnest money or other deposits paid to the seller.
Another example of liquidated damages could be in a construction contract. If a construction company or contractor suffers delays, then they may be forced to pay liquidated damages to the other party. The amounts owed would be outlined in the contract (for instance, $2,000 per day for every day construction is delayed).
While the following is not considered an example of liquidated damages, it may better explain the difference between liquidated damages and other, punitive damages: if a highly customized product is faulty, liquidated damages may not be a reasonable cure for the injured party. In this case, the injured party would likely file a lawsuit for actual losses, seeking lost profits or other additional costs.
Liquidated damages typically only apply when the following conditions are met:
The liquidated damages are a fair estimate of potential damages when the contract is signed.
The liquidated damages must be considered reasonable even if they are difficult to estimate. In other words, the amounts cannot be arbitrary, unrealistic or punitive.
When the contract is drafted, there must be a reasonable and well-defined estimate of the damages to make sure this clause can be enforced. Even if the parties agree on what is reasonable, it’s possible a court may disagree, and the liquidated damages clause may not be legally enforceable.
Additionally, circumstances change over time, which can render the original contractual amounts unsuitable. Therefore, the liquidated damages clause should be reevaluated, especially over longer-term contracts.
How Do Liquidated Damages Differ from a Penalty Clause?
Both liquidated damages and penalty clauses are mechanisms for a party to pursue if another party breaches a contract. However, they are different in many ways.
The purpose of liquidated damages is to provide a measure of certainty as to what parties can expect if a contract is breached, especially if the damages are difficult or costly to quantify. These amounts are expected to be reasonable and to effectively reimburse one party for potential damages. Liquidated damages are also meant to simplify and expedite compensation to the injured party.
In contrast, a penalty clause is intended to completely deter a contractual breach by imposing a punitive cost to the breaching party, not simply covering a counterparty’s potential loss, as in liquidated damages. Because of this, penalties cost significantly more than liquidated damages.
Depending on the jurisdiction, liquidated damages clauses are generally enforceable, assuming they are considered reasonable. However, penalty clauses may not be enforceable and would most likely need to be litigated in court or determined by an arbitration panel. Because of this, penalty clauses are usually less common in contracts, relative to liquidated damages clauses.
In summary, liquidated damages provide predictability and certainty for both parties in a contract. Since the amounts are known in advance, both parties will have better information for decision-making and risk management.
However, the liquidated damages clause must be carefully negotiated and drafted, as well as be based on a reasonable estimate of potential damages, otherwise the clause may be struck down by a court.
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