A liquidated damages clause specifies a predetermined amount of money that must be paid as damages for failure to perform under a contract. The amount of the liquidated damages is supposed to be the parties’ best estimate at the time they sign the contract of the damages that would be caused by a breach. While liquidated damages provisions can have advantages, they are not always enforceable. If the predetermined amount of damages ends up grossly disproportionate to the actual harm suffered, courts will refuse to enforce the provision on the grounds that it is a penalty instead of an estimate of actual damages.
To be enforceable, a liquidated damages clause should meet the following criteria.
Damages are difficult to estimate. A court will be more likely to enforce a liquidated damages provision if the damages that will be incurred as a result of a breach of the contract are difficult to estimate when the contract is entered into. In certain situations, injuries are easy to prove. For example, if a breach will result in the loss of sales, it is easy to determine the actual damages by calculating lost profits. Others are more difficult, like the harm caused by breach of a confidentiality agreement or theft of trade secrets. To be enforceable, the damages should be either uncertain or difficult to quantify at the time the contract is entered into.
The amount is reasonable and not a penalty. If the amount of the liquidated damages is grossly disproportionate to the actual harm incurred, a court will likely find it is a penalty or punishment and will not enforce the provision. When making this analysis, courts usually consider what was reasonable at the time the contract was entered into as opposed to when the breach occurred. There have been cases, however, where courts will decide the reasonableness of the damage estimate based on the actual harm at the time of the breach. This actual harm analysis is how the Uniform Commercial Code decides the reasonableness of liquidated damages provisions in contracts for the sale of goods.
Most states have laws governing the use of liquidated damages provisions in contracts. Some are general and simply state that the liquidated damages must be reasonable under the circumstances existing at the time the contract was entered into. Others are more specific and may even include specific language that must be included in the liquidated damages provision.
In deciding the reasonableness of a liquidated damages provisions, courts often consider the relative bargaining power of the parties. For example, liquidated damages provisions in preprinted consumer contracts, like car rental agreements and club memberships, are generally subject to higher scrutiny because of the disparity between the relative bargaining power and sophistication of the parties involved. On the other hand, courts are less likely to invalidate a negotiated agreement between two attorneys.
Assuming you get over the hurdles related to enforceability, liquidated damages clauses have certain benefits. They establish some predictability and can act as a type of insurance against the cost of a breach. Both parties have the advantage of being able to weigh the cost of performance against the cost of breach. In addition, the nondefaulting party never has to prove actual damages, which can be a time consuming and difficult task. Done properly, deciding on damages at the outset gives both parties the opportunity to settle on an amount that they think is fair instead of leaving this decision to the courts. Besides the uncertain of litigation, it is also time consuming and costly.