A liquidated damages clause is a provision that sometimes appears in contracts when it would be difficult for one party to the agreement to calculate damages should the other party decide to breach the contract.
Since that statement is extremely confusing, let’s try to break down what that actually means.
What are Liquidated Damages?
Whenever the obligations of one party to a contract are not fulfilled (known as a breach of contract), the other party generally suffers a “damage” because of it. If a contract is breached, a court will generally look to make the other party “whole” again. However, this is often difficult to measure. Liquidated damages is a way of quantifying compensation for a loss that is uncertain or hard to measure. While liquidated damages can be awarded by a judge in the event of a lawsuit for breach of contract, they can also be agreed upon by the parties prior to the breach taking place in the original contract they are entering into.
Advantages to Having a Liquidated Damages Clause
Having a liquidated damages clause has many advantages. Primarily, the main advantage to having a liquidated damages provision is predictability. The reality of the situation is that contracts are breached all the time. Rather than having a court decide how much damages should be awarded if one party breaches a contract (which by the way, will add a significant amount of legal fees required to reach this decision), the parties can settle on an amount that is mutually agreeable to the parties – prior to any dispute actually having taken place. Additionally, another important advantage to having a liquidated damages clause is due to it allowing both parties to make more calculated decisions when the contract is actually being performed. If both parties to a contract know the cost that will result from breaching a contract, the parties can balance the cost of breaching the agreement or simply fulfilling the agreement – this may actually result in more contracts not resulting in a breach.
Requirements for Liquidated Damages Provisions
Not all liquidated damages clauses will able to be enforced. There are many rules which vary from state to state as to what is required for a liquidated damages provision to be upheld by a court.
The Injury Suffered Is Difficult to Determine or Calculate
If damages are easily determined and calculated, there is no need for a liquidated damages provision. The best way to understand this is by examples.
- Example of Regular Damages – Liquidated Damages Not Necessary
- If Ron offers to build Susan a computer for $2,000 and Susan agrees – if Ron fails to fulfill the contract and Susan is forced to get someone else to build her a computer (of similar specifications) for $2,500 – Susan suffers a damage of $500. This is easy to calculate and would not require liquidated damages.
- Example of Liquidated Damages Being Necessary
- If Susan makes an offer to purchase Ron's home and includes a $5,000 deposit but Susan backs out of the deal, damages are difficult to determine. Here, Ron suffers an injury because he loses out on someone buying his home, has put in some work towards having Susan purchase his home, and may suffer due to market changes in the housing market. Because these injuries are difficult to determine, a liquidated damages may be necessary to award damages. In this example, a liquidated damage clause would commonly require Susan to forfeit the deposit she made.
Liquidated Damages Does Not Equal Penalty
A liquidated damages clause is not a penalty. A penalty is usually more than the actual damages and is meant to punish the offending party or prevent a breach of contract. Liquidated damages clauses protect both parties in a contract and provide a predictable way to settle the issue of lack of performance by either party.
Liquidated Damages Must Be Reasonable
Liquidated damages must be reasonable and take into account the actual harm done by the breach, and there must not be a more suitable remedy available. Returning to our real estate example, if Ron insists on a $20,000 deposit from Sue, only a portion of that would probably be allotted as liquidated damages since most breaches in real estate contracts involve putting the property back on the market, not actual physical damages or financial loss (other than the cost of the time to arrive at the ultimate sale). Thus, in this example, $5,000 would be reasonable while $20,000 would not be.
Liquidated damages clauses can be very advantageous if drafted properly. Whether you are thinking about including one in your next contract or were presented an agreement that contains a liquidated damages provision, it is important to have a contract lawyer or business lawyer familiar with contracts assist. Should you wish to discuss this further, Cordero Law can help. Call us for a free consultation and learn more about this issue.
Julian Cordero is an Attorney, Music Producer, and Entrepreneur. Oh and he blogs too! Julian is licensed to practice law in New York and is the Managing Member of Cordero Law LLC, a New York City based law firm focusing on Business Law, Entertainment Law, and Intellectual Property.