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Liquidated Damages

When, as a first-year law student, I learned about liquidated damages clauses in my contracts class, I thought they sounded like a magical tool that would prevent anyone from ever getting stiffed in a deal. And to a certain degree, liquidated damages clauses do provide a measure of security. They certainly can be a useful tool to reduce uncertainty in contractual agreements. However, my contracts course proceeded to traipse through the history of cases where courts did not enforce liquidated damages clauses. Thus, if one is to harness the magic of a liquidated damages clause, it is imperative to know a little bit about them in order to make sure that your clause will actually save rather than create litigation.

So, what is a Liquidated Damages Clause?

A liquidated damages clause is the inclusion of a clause that expressly says what the damages to be paid will be in the event either party breaches the contract. The idea is that by expressly specifying a predetermined amount of money that will be paid as damages, both parties, at the time of signing the contract, agree to pay these damages and the parties are then better protected in the event of a contractual fall out.

A liquidated damages clause will typically look something like this:

“If Seller breaches its obligation to deliver goods in accordance with the schedule provided for in this contract, Buyer will be entitled to recover $x.x per day for each day of delay as liquidated damages.”

See how a liquidated damages clause might seem so dreamy? It seems that a liquidated damages clause would provide total peace of mind—should the contract go awry, there is a very explicit consequence laid out within the contract that both parties agreed to! Well, perhaps you will not be surprised when I say it is not quite that simple. As a matter of fact, a liquidated damages clause can actually facilitate the litigation is seeks to eradicate.  

Liquidated Damages Clause Challenges

There are two important things to remember when drafting a liquidated damages clause:

  • The damages should be difficult to calculate.

By this, I mean that the nature of the agreement should be such that calculating the damages in the event of the breach will be an arduous task. A court is more likely to enforce a liquidated damages clause when the damages stemming from the breach are difficult to calculate. However, it is worth mentioning that liquidated damages clauses are rarely invalidated simply because damages are easily calculated.

  • The liquidated damages should be reasonable (cannot amount to a penalty).

This means that the agreement must be a reasonable and genuine prediction of the damages that would be caused by breach of the contract. Reasonableness will be measured in light of the time at which the contract was drafted. So, let’s say you are a coffee trader, contracting for the shipment of coffee. If at the time of contracting the coffee was worth $2.50/lb, your liquidated damages clause would calculate damages at that rate. If the coffee market subsequently sharply drops, and your liquidated damages clause now looks unreasonable, fear not because it was reasonable at the time that you made it.

Reasonability of the liquidated damages is an incredibly important aspect of your liquidated damages clause. Throughout all of contract law, there is a general distaste for penalties. Courts are hesitant to impose a penalty even on the most egregious breaching party, and, similarly, they will be hesitant to enforce liquidated damages so extravagant their effect is similar to that of a penalty. The short of it is that courts do not like penalties. So, it behooves you to ensure that your liquidated damages clause is not so unreasonable that a judge will interpret it as a penalty. Because if they do, they will invalidate the clause and impose their own idea of fair damages.

Another aspect of reasonableness that a court will take into consideration is the relative bargaining power of the parties. For example, a general consumer contract is likely to be subjected to higher scrutiny because of the disparity of bargaining power of the parties involved. However, an agreement negotiated by both parties’ attorneys is much less likely to be thrown out because of disparity of bargaining power.

Drafting Tips

Liquidated damages clauses offer many benefits. They allow the parties to better weigh the cost of performance against the cost of breach. They help avoid the process of having to prove actual damages—which is almost always cumbersome. They allow the parties themselves to determine what amount they think is fair. Finally, if drafted properly, they help to avoid costly litigation.

In order to draft an effective liquidated damages clause, you should always make sure your agreed upon damages have a reasonable relationship to the actually anticipated damages. It may also be helpful to incorporate the rationale behind the clause. You might include something that expressly indicates that the parties agree to quantify damages in the contract because of the inherently difficult nature of calculating losses. Furthermore, you might include that parties agree that the liquidated damages are not a penalty. While this will not ensure that a court will enforce the clause, it will have the effect of chipping away an opposing party’s arguments that the clause is unreasonable and amounts to a penalty.

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