What are “liquidated damages”?

Liquidated damages are an agreed-upon amount of money that parties to a contract promise to pay if one of them breaches the contract.

Unlike other types of damages, such as actual damages and punitive damages, liquidated damages typically only come into play when there is a contract involved. The amount of liquidated damages is usually agreed upon ahead of time and written into the contract. The parties to a contract might also agree ahead of time on what kinds of actions will require a payment of liquidated damages. For instance, a buyer and seller of widgets might agree that the seller will pay liquidated damages if he cannot deliver the widgets on time, but not if he cannot deliver the correct number of widgets.

In some contracts, the parties will agree ahead of time that liquidated damages should be paid in certain situations, but they will not specify a dollar amount. In these cases, the amount is said to be “at large,” and a judge or jury will usually determine the amount if the dispute goes to court.

A liquidated damages clause must meet two conditions for the court to uphold it:

  • The amount of liquidated damages must be roughly equal to the amount that the party who is owed the damages will lose due to the breach of contract, and
  • The damages must be uncertain enough that the liquidated damages clause saves both parties substantial time and money in figuring out the actual damages amount.

If damages are extremely uncertain or impossible to figure out, they may be referred to as “unliquidated damages.” Damages that depend on a certain event occurring or not occurring may also be called “unliquidated damages.” For example, suppose the defendant promised to lease a storefront to the plaintiff on or before April 1. The plaintiff planned to open a bakery in the store. However, the defendant did not actually lease the storefront to the plaintiff until May 15. The amount of money the plaintiff might have made in the month-and-a-half between April 1 and May 15 is speculative; the court can only guess how much would have been made. If the leasing contract has a liquidated damages clause specifying how much the defendant should pay, the court will likely enforce it unless the amount is unreasonable or meant to be a punishment.

A liquidated damages clause cannot be used to punish either party for breaching the contract.  If the parties want to set aside an amount as punishment for a breach, they can use a “penal clause” or a “penalty clause,” which lists the amount of a penalty that will be imposed if certain events occur. For instance, a contractor who doesn’t finish a project on time may have to pay a penalty amount. Not all types of contracts, however, may include a penalty clause. The Uniform Commercial Code prohibits penalty clauses in most sales contracts, for instance.

Parties might want to employ liquidated damages clauses for several reasons. First, liquidated damages put a price on costs that are difficult to determine ahead of time, so they give the parties a standard by which to measure losses or benefits if they are trying to decide whether or not to breach the contract. Liquidated damages also allow the parties to a contract to work out for themselves ahead of time the amount the damages will be, instead of leaving that number for a judge or jury to determine. Since the parties to a contract are usually the ones closest to the business the contract covers, they can usually estimate an appropriate amount for liquidated damages more easily than a court can.

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