A liquidated damages clause is a provision that serves as a remedy for breach of contract. It obligates the defaulting party to pay a specified amount of money to the other party as damages for failing to fulfill the performance criteria. Although it offers some benefits, a liquidated damages clause is not always valid in the eyes of the law. It must meet certain requirements in order to be enforceable. Laws pertaining to liquidated damages may vary from one state to another and can be general or specific.

What Are Liquidated Damages?

Liquidated damages are a form of monetary compensation that is awarded through a court judgment or contract stipulation for a loss or injury to the rights or property of a person that results from a breach of contract. A contract that involves the promise of performance or monetary exchange generally has a liquidated damages stipulation. This stipulation specifies a predetermined amount of money that must be paid in the event that a party to the contract is unable to perform as promised.

Liquidated damages is a sum of money that is estimated to be equal to the extent of loss or injury that may occur as a result of a contract breach. Such damages are determined while a contract is being drafted and serve to provide protection for both contracting parties, regardless of their roles in the contract.

What Is a Liquidated Damages Clause?

A liquidated damages clause is a provision that states how much monetary compensation must be paid if one party to a contract fails to fulfill his or her contractual obligations. The amount of compensation is supposed to be the best estimate the contracting parties can come up with before they sign the contract.

It is beneficial to include a liquidated damages provision in a contract, but such a provision is not always enforceable by law. If the predetermined compensation is highly disproportionate to the actual loss or injury sustained, the court will declare the provision void on the grounds that it seems more like a penalty than a proper estimate of actual damages.

Benefits of Using a Liquidated Damages Clause

If you are able to overcome the obstacles related to enforceability, you can expect to reap certain benefits from having a liquidated damages clause in your contract. Firstly, the clause establishes some predictability and provides protection from injury or loss resulting from a breach of contract. It enables both parties to a contract to compare the cost of performance with the cost of a breach.

Additionally, a liquidated damages clause does not require the non-defaulting party to perform the potentially difficult and time-consuming task of proving actual damages. When it is properly done, it allows both parties to agree on an amount of compensation that they think is fair rather than letting the court make the decision. Litigation can be an uncertain, costly, and time-consuming process.

Criteria for an Enforceable Liquidated Damages Provision

In order to be legally enforceable, a liquidated damages provision should meet the following requirements:

  • Damages are hard to estimate – There is a higher chance that the court will enforce a liquidated damages clause if the damages expected to result from a contract breach were difficult to estimate when the parties entered into the contract. Injury can be easily proven in certain situations.
  • A predetermined amount of damages is reasonable – If the estimated amount of compensation for a breach of contract is significantly disproportionate to the actual detriment caused, it is likely that the court will consider it a penalty and will declare the clause void. When it is making this analysis, the court will attempt to determine the reasonable amount at the time the parties signed the contract as opposed to when the contract was breached.

Check Your State's Liquidated Damages Laws

In most states, there are laws pertaining to the use of liquidated damages clauses in contracts. Some of these laws are general, simply stating that the damages must be reasonable when the parties agreed to enter into the contract. There are also laws that are more specific and may require liquidated damages provisions to contain specific language.

If you need help creating or enforcing a liquidated damages clause, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.