Key Takeaways

  • Liquidated damages are pre-agreed amounts written into contracts to cover losses from a breach, distinct from punitive damages.
  • Courts enforce liquidated damages only if they are a reasonable estimate of actual loss and not an excessive penalty.
  • These provisions are common in construction, employment, and supply contracts where damages are hard to measure.
  • If damages are uncertain, courts may strike down a liquidated damages clause that appears punitive.
  • Including clear, fair liquidated damages clauses in contracts can reduce disputes and litigation risks.

What is the meaning of liquidated damages? When you sign a contract, it will typically include a section that outlines the amount of money, or liquidated damages, that one party will pay to the other if the contract is breached or if one of the parties takes legal action.

Definition of Liquidated Damages

Liquidated damages are the amount of money that both parties in a contract agree upon if a breach of contract occurs or legal action arises as a result of the contract breach. If one of the parties breaches the contract, it agrees to pay the liquidated damages to the other party. Liquidated damages are generally only applicable to contractual agreements, which separates them from punitive and actual damages.

The parties involved in a contract will typically agree on the amount of liquidated damages at the time the contract is signed and include the details in the agreement. Those signing the contract may also choose to include information on what types of actions would require that one party pay liquidated damages to the other party. For example, if a software developer agreed to deliver a set number of widgets but couldn't deliver that number and/or couldn't meet the deadline, that developer might have to pay liquidated damages.

Purpose of Liquidated Damages

Liquidated damages serve multiple purposes in a contract. They provide predictability for both parties by removing uncertainty about how much a breach might cost. This predictability can also deter breaches because the party at risk knows in advance the financial consequences. Additionally, liquidated damages can save time and expense by eliminating the need for lengthy litigation to determine actual losses. Courts, however, will not enforce them if they are disproportionate or intended as a penalty rather than compensation

At-Large Damages

Some contracts include an agreement between the two parties that outlines what situations require the payment of liquidated damages, but that doesn't state the specific dollar amount of those damages. In this case, the amount is considered to be "at large," so a judge will make the determination of how much must be paid if one of the parties takes legal action. In other cases, the amount of liquidated damages is based on the down payment or deposit. This amount could also be a percentage of the total contract.

The party that doesn't default on or breach the contract may take legal action to receive liquidated damages, although this usually requires proof written into the contract that liquidated damages are not specified. However, if the party taking legal action can prove that the amount was too high or too low, a judge may alter the amount of the required payment. This usually indicates that the contract contained a misunderstanding, was fraudulent, or was written unfairly. 

Damages are liquidated when either of the following applies:

  • If no known rules apply to outline the certainty of the damages, whether due to the case circumstances or the nature of the contract's subject
  • If the tenor of the agreement and the nature of the case indicate that the damages are calculated and adjusted fairly between the involved parties

This payment is to compensate for an injury, detriment, or loss to an individual, the individual's property, or his or her rights, based on a stipulation in a contract or an award by a judge. A contract that includes details about promised performance or exchange of money will usually include a stipulation concerning liquidated damages. This stipulation exists to determine a set amount of money that will be paid if one of the involved parties fails to deliver on the promised terms.

Common Uses of Liquidated Damages

Liquidated damages are especially common in industries where performance delays or failures can create cascading losses that are difficult to quantify. Examples include:

  • Construction contracts – missed completion deadlines can trigger daily liquidated damages.
  • Supply agreements – delays in delivery of essential goods may justify pre-agreed damages.
  • Employment contracts – restrictive covenants, such as non-compete clauses, may include liquidated damages provisions.
  • Government contracts – public projects often use liquidated damages to ensure timely performance.

By including these provisions, parties can avoid disputes about actual damages, which are often difficult to prove.

When Liquidated Damages Apply

Liquidated damages only apply when:

  • The contract doesn't specifically quantify the injury or the amount of damages required.
  • The contract structures damages to function as damages but not as a penalty.
  • The amount of harm anticipated as a result of the breach of contract is reasonable.

The liquidated damages provision in an agreement must be reasonable, based on the actual or anticipated harm that occurs as a result of the breach. If the amount is unreasonably high, it will not be enforceable, based on the public policy of penalty.

Enforceability of Liquidated Damages

Courts apply a two-part test to determine enforceability:

  1. Uncertainty of damages at the time of contracting – the actual harm must be difficult or impossible to estimate when the contract is signed.
  2. Reasonableness of the amount – the liquidated damages must represent a fair forecast of potential loss, not a penalty.

If the amount is excessive and intended to punish rather than compensate, courts will likely strike it down. U.S. courts, as well as many international jurisdictions, follow this principle to prevent unjust enrichment.

Including Liquidated Damages in a Contract

When drafting a contract, if you plan to include a section on liquidated damages, you will need to make a logical, well-founded estimate to make sure it can be enforced. This amount should be an estimate of the full extent of injury that could happen in the event of a contract breach. 

Liquidated damages protect both parties when they enter into their contract, regardless of the relationship between them. A contract between employer and employee or buyer and seller could include a section about liquidated damages. This term refers to a variety of damages that could result if a contract is breached. 

Drafting Effective Liquidated Damages Clauses

When drafting a liquidated damages clause, clarity and fairness are essential. Best practices include:

  • Base the damages on reasonable calculations tied to potential loss, not arbitrary numbers.
  • Specify triggering events clearly, such as late delivery or failure to perform a defined obligation.
  • Avoid punitive intent by ensuring the damages are proportionate to the anticipated harm.
  • Comply with governing law since different states or countries may have varying rules on enforceability.

Well-drafted liquidated damages provisions help protect business relationships and minimize litigation. If a dispute does arise, courts are more likely to enforce clauses that are thoughtfully drafted and supported by evidence of reasonableness.

Frequently Asked Questions

1. What is the meaning of liquidated damages?

Liquidated damages are a pre-agreed sum specified in a contract that one party must pay to the other if they breach the agreement.

2. How do courts decide if liquidated damages are enforceable?

Courts enforce them only if actual damages were hard to estimate at the time of contracting and the amount is a reasonable forecast of potential loss.

3. Are liquidated damages the same as penalties?

No. Penalties are meant to punish, while liquidated damages are compensatory. Courts generally refuse to enforce penalty clauses.

4. Where are liquidated damages most commonly used?

They are widely used in construction, supply, employment, and government contracts where losses from delays or breaches are difficult to measure.

5. Can liquidated damages be challenged in court?

Yes. A party can challenge them if they are excessive, unreasonable, or not tied to actual anticipated losses.

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