1. What Makes a Liquidated Damages Clause Valid?
2. What Contracts Use a Liquidated Damages Clause?
3. Advantages of a Liquidated Damages Clause

A valid liquidated damages clause goes into effect when one party in a contract breaches the terms, resulting in a loss or injury to a person, a person's rights, or a person's property. Damages are a monetary sum, awarded by either a contract stipulation or a court judgment.

Liquidated damages stipulations are usually contained in contracts that include an agreed-upon performance or a money exchange. If one party violates the terms of the agreement, they must pay a pre-established sum to the non-defaulting party. The compensation of liquidated damages can vary; the amount of a down payment or deposit or a percentage of the contract amount are commonly used.

What Makes a Liquidated Damages Clause Valid?

Damages can only be liquidated under the following circumstances.

  • If an injury is "difficult to quantify" or "uncertain."
  • The sum must be reasonable and include any actual or likely damages.
  • It must also consider how difficult it may be to prove a loss and find an adequate solution.
  • The damages should not be a penalty. Monetarily unequal to the harm done, penalties serve as a reason to not break the contract, and are allowed when the obligations of a contract were not fulfilled. The reason these payments are considered damages instead of penalties can be traced back to courts of equity, which attempted to deter parties from making Unconscionable bargains.

Liquidated damages clauses will be voided if these stipulations are not met.

A non-defaulting party will be able to get a judgment for liquidated damages unless the defaulting party can make a strong argument that the amount was too high for the circumstances or that fraud, basic unfairness, or a misunderstanding occurred. However, in some instances, a court may find that the liquidated damages do not accurately reflect the circumstances of the case.

Generally, the validity of a liquidated damages clause should be easily understood from the above list; however, courts have been inconsistent in their determinations. When drafting contracts, parties will sometimes include language that states that the damages are "liquidated and not a penalty," but courts do not always recognize that boilerplate as correct. Instead, it would be more persuasive to state a reason for the amount chosen.

What Contracts Use a Liquidated Damages Clause?

These clauses are usually included in real estate contracts. If a buyer defaults, the clause will help them minimize their loss; while sellers are granted the deposit money from the buyer as compensation for a breach.

Franchise agreements generally include a liquidated damages clause, even if many franchisees agree to them without much thought. If a franchisee breaches the agreement, they may be subject to pay a large sum to the franchisor. Income to the franchisor is variable and dependent upon the income of the franchisee; therefore, the liquidated damages clause protects the franchisor in the event of a breach.

Government infrastructure contracts are another example of contracts where liquidated damages are included for delaying the completion of a process. They are generally assigned on a per day basis, meaning a set amount of money is assigned for each day that a project is late. Although these clauses are very common, they are not always enforced. If the amount of liquidated damages is found to be much larger than the scope of the project, it will be rejected and viewed as a penalty.

Advantages of a Liquidated Damages Clause

Liquidated damages clauses provide a couple of advantages. Since both parties are able to estimate costs of performance versus contract breach, the clause functions as limited insurance. During contract negotiations, both parties must settle on a mutually agreeable sum for the liquidated charges, so they do not need to incur the cost of legal fees for a court decision.

Estimated damages are established when the contract is created and will cover the sum equal to the extent of the injury that may occur should one party breach the contract. If a precise dollar amount is agreed upon when drafting the contract, damages will be awarded in that amount if a breach occurs. In such a case where a breach occurs, actual damages do not need to be proven.

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