What are Liquidated Damages?
How do you legally define it?
What are the essential elements you should know!
In this article, we will break down the notion of Liquidated Damages so you know all there is to know about it!
Keep reading as we have gathered exactly the information that you need!
Let’s dig into the legal concept of “liquidated damages” and see how it works!
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Table of Contents
What Are Liquidated Damages
Liquidated damages are contractually defined amounts, agreed by the parties, establishing the damages a party may recover from the other in the event of a breach of contract or default.
The amount specified for liquidated damages represents the parties’ estimate of how much the non-breaching party may suffer in actual damages if there’s a breach of contract by the other party.
Typically, you may see liquidated damages (or liquidated and ascertained damages) in cases where a party’s injuries or damages are hard to prove or intangible.
For example, you are likely to see liquidated damages in construction contracts for late performance or joint ventures for damages suffered by misappropriation of trade secrets or breach of confidentiality provisions.
In addition to construction contracts, you may find a liquidated damage clause in subcontracting agreements, software development contracts, joint ventures, teaming agreements, and many more.
Very often, the liquidated damages provision in a contract will define the amount the breaching party will need to pay per day of breach or per missed milestone.
For example, the contract may state that in case a subcontractor fails to deliver its work on time, it may be exposed to $100 of penalty per day of delay.
The ultimate objective of contracting parties in agreeing to include liquidated damages provision in their contract is to increase certainty and avoid legal costs when actual damages are difficult to prove.
Liquidated Damages Definition
How do you define liquidated damages?
According to Cornell Law School’s Legal Information Institute, the definition of liquidated damages is:
Liquidated Damages are a variety of actual damages. (…) Parties to a contract use liquidated damages where actual damages, though real, are difficult or impossible to prove.
This is the case as the purpose of “liquidated damages” is to contractually quantify actual damages.
Why Include A Liquidated Damages Clause
Agreement to liquidated damages in contracts can provide the parties with some benefits.
In fact, the most important reason why contracting parties may think of a “liquidated” damages provision is to ensure they have predictability over the possibility of contractual inexecution.
Right from the beginning, the parties can negotiate and mutually agree on a fair and reasonable “penalty” to pay compensating the other party for any delays.
From the non-breaching party’s perspective, the liquidated damages allows it to recover damages against the other party’s default without having to get into the complexities of proving actual damages.
Consider it like an insurance policy against the other party’s breach of contract.
From the breaching party’s perspective, it allows them to pay a predictable penalty for breaching the contract regardless of the non-breaching party’s actual damages.
In other words, the breaching party can assess its contract risk from the beginning and avoid being exposed to unpredictable and astronomic sums the non-breaching party may potentially claim.
Are Liquidated Damages Provisions Enforceable
In most jurisdictions, laws and statutes govern the application and enforceability of liquidated damages in a contract.
In general, a “liquidated damage” provision is not going to be easy to enforce in court.
Although you’ll need to consider the local requirements to succeed in enforcing the damages defined under contract in the event of breach, the courts will assess the provision based on the following parameters:
- Is the actual damage difficult to quantify by the non-breaching party?
- Can the damage be agreed upon in advance?
- Are the amounts reasonable?
- Is the amount compensating the non-breaching party or acting as a penalty to the breaching party?
- Are there other remedies that could have been enforced?
If a party took advantage of its negotiating power to impose a provision that is unfair, acts more as a penalty than a reasonable compensation, where other remedies could have been exercised, or the clause was unreasonable, the courts may choose not to enforce the clause.
Liquidated Damages Example
Let’s look at a few examples of when we use liquidated damages in a contract.
In the software world, a software developer’s source code is considered a trade secret to the extent it is private and not shared with others.
Although the software developer recognizes that its trade secret has value, it may be very difficult to prove that someone else misused it or disclosed it to the public.
If that were to happen, the value of the trade secret will significantly drop.
As a result, in contracts where source code may be shared or trade secret exchanged, it is common to see liquidated damage clauses where the source code owner or trade secret owner “liquidates” its potential loss if the other party breaches the disclosure provisions or breaches the contract.
When a company is in the design phase of a product, it may be necessary to retain the services of external experts to finalize and validate the design.
Sharing product design and plans may not have an actual market value at the time they are shared as the underlying product is yet to be built.
However, the product may have a market value of millions of dollars, if not billions.
In this case, when a company or manufacturer shares designs or concepts with another firm, it may likely include liquidated damages provisions in its contract to account for the possible loss should the other party disclose the plans to the outside world or misuse it.
The plans and designs are trade secrets that have value but the actual losses may be difficult to quantify.
Liquidated Damages vs Penalty
When the amount of liquidated damages are unreasonable, grossly disproportionate to the actual harm incurred by a party, or serves more as a “punishment” than as a means to calculate a party’s actual losses, the courts will not enforce the provision.
Liquidated damages is essentially a formula or means to calculate, in advance, “actual” damages a party may suffer should the other party fail in its contractual performance.
The objective of the liquidated damages provision is not to enrich the non-breaching party but to compensate for actual and reasonable losses caused by the breach.
For example, if a party’s actual losses amount to $100 per day when there is late delivery, the non-breaching party would not be able to enforce a penalty of $1,000 per day.
In this example, $100 reasonably compensates the party’s actual loss but $1,000 is disproportionate to the actual harm incurred by the non-breaching party.
In essence, a penalty clause is not enforceable but fair and reasonable liquidation or estimation of actual damages in a contract may be enforced.
Liquidated Damage: Takeaways
So, what are Liquidated Damages?
Let’s look at a summary of our findings.
Liquidated Damages Meaning
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