A liquidated damages clause can be a useful tool in a contract to reduce uncertainty and the time and resources spent on potential disputes. Liquidated damages clauses specify the amount of damages to be paid by the breaching party in the event of certain types of breaches as defined in the contract by the parties. The amount of liquidated damages represents the contracting parties’ best guess as to the amount of anticipated or actual damages that would be incurred by the non-breaching party in the event of a specified breach of the contract by the other party.
There are steps you can take in determining the liquidated damages amount and drafting your contract to make sure courts uphold the liquidated damages provision. Of course, while this post discusses liquidated damages clauses generally, you should also research how the jurisdiction applicable to your contract treats liquidated damages.
Contracting parties typically agree to liquidated damages where the damages would otherwise be uncertain or difficult to prove or calculate. Courts will generally uphold a liquidated damages clause that is reasonable in the context of the case and will consider several factors in determining whether such clause is reasonable, including the following:
- Whether the damages in question are difficult to calculate at the time of contracting due to indefiniteness or uncertainty, or are difficult to prove
- Whether the amount of liquidated damages is a reasonable forecast of the actual damages that would be or have been caused by the type of breach in question
While evaluating the foregoing factors, if a court finds the liquidated damages amount to be excessive or that actual damages would have been easy to calculate at the time of contracting, the related contract provision will be considered a penalty and therefore void. In order to pass muster by the courts, the liquidated damages clause should specify the contracting parties' reasoning for employing a liquidated damages provision, the reasonableness of the amount of such damages, and the provision's interaction with other damages provisions.
A liquidated damages clause should include the following:
- What types of breach trigger the liquidated damages provision
- Why the parties are agreeing to liquidated damages (i.e., why the actual damages caused by the type of breach in question would be difficult to calculate at the time of drafting, uncertain, or otherwise difficult to prove)
- The amount of liquidated damages or a formula to calculate the liquidated damages in the event of the type of breach in question
- The intent of the parties that the liquidated damages amount be a fair estimate of the actual damages suffered in the event of the type of breach in question
- In the event of a breach that triggers the liquidated damages provision, the liquidated damages are the exclusive remedy of the non-breaching party (i.e., make sure that if your contract has a cumulative remedies provision, it does not apply to breaches that trigger the liquidated damages provision and associated remedy)
If seen as an enforceable liquidated damages clause, courts will not look to actual damages suffered to make a party whole. For this reason, it is important to carefully draft liquidated damages clauses in your contracts.