Understanding Liquidated Damages

Many contracts today include clauses for liquidated damages, especially in construction contracts.  A company should make sure it understands the purpose and limits on enforceability of such clauses prior to signing a contract.  Failure to properly draft a liquidated damages clause may result in increased liability or a court determining the clause to be unenforceable.   

Liquidated damages means simply damages that are agreed upon ahead of time at the contract formation stage, as opposed to damages that are determined in court after the contract is breached.  Parties to a contract may use liquidated damages if the damages for a breach of contract would be difficult to ascertain at the time of contract formation. 

If liquidated damages are appropriate for a contract, the amount chosen must not be extravagant or unreasonably disproportionate to the damages that would actually result from a breach of contract.  Courts generally do not enforce liquidated damages that are intended to serve as a penalty or are far in excess of the amount of damages the parties may reasonably forecast.  Reasonableness of the amount of liquidated damages is determined from the standpoint of the parties to the contract at the time the contract was made.

When drafting a liquidated damages clause, the clause should include language acknowledging that the damages due to a breach would be difficult to ascertain and that the amount is not meant as a penalty.  Additionally, if the liquidated damages amount is challenged as a penalty, the defense of the clause may be helped if the clause includes language listing some of the damages that were considered when determining the amount to use as liquidated damages (e.g. loss of goodwill, loss of sales, re-procurement costs, breach of higher tier contract).