What Are Liquidated Damages?

The term “liquidated damages” refers to a predetermined, fixed sum agreed upon in a contract to compensate the non-breaching party for the anticipated loss resulting from a breach, regardless of the actual damages incurred.

The Uses (and Abuses) of Liquidated Damages

As a general matter, contract remedies are not meant to be punitive (that is, punish the breaching party). Instead, they are designed to 'make whole' the party affected by a breach, restoring them to the position they would have been in if the contract was fully performed. The ability to effectively achieve this hinges on the ability to accurately quantify the actual harm suffered by the non-breaching party due to the breach. 

This can be problematic in cases where there is no historical financial data to gauge expectation damages, as is often the case with new business ventures, or consequential damages are difficult to ascertain at the contract's outset, such as with contracts involving complex projects where delays can have cascading effects but the exact extent of harm is uncertain. In these situations, liquidated damages can be essential to provide a clear, agreed-upon framework for compensation, thereby reducing the need for costly and time-consuming litigation to prove actual damages.

While liquidated damages can offer significant benefits, they also have the potential for misuse, particularly in situations with unequal bargaining power. For instance, consider a large hotel chain and a local contractor engaged in a $100,000 hotel construction project. An unfairly imposed clause stating that if the project isn't completed within six months, the contractor will receive no payment and owe the hotel chain $30,000 for lost revenue exemplifies such abuse.

Factors Considered by Courts in Determining Whether to Enforce Liquidated Damages Clauses

For the reasons discussed above, courts will often scrutinize liquidated damages clauses closely and invalidate them when they deem a clause to be punitive, rather than a reasonable forecast of the damages anticipated due to the breach. For these purposes, courts will examine the following factors:

• Whether the amount specified in the liquidated damages clause represents a reasonable estimation of the expected loss due to the breach. This estimation should be grounded in reality at the time of contract formation rather than a figure that appears arbitrary or excessive. 
• Whether at the time of the agreement, it was evident that determining the actual damages would be difficult or impossible in the event of a breach. 
• Whether the process of agreeing upon the liquidated damages reflects good faith negotiations between the parties. This implies that both parties had a fair opportunity to discuss and agree upon the amount, indicating mutual consent and understanding.

Best Practices for Drafting Enforceable Liquidated Damages Clauses

To ensure that liquidated damages are considered fair and reasonable, (and therefore legally binding), it is advisable to:

• Establish a Reasonable Estimate: The amount set as liquidated damages should be a genuine pre-estimate of the loss that might result from the breach. It should not be arbitrary or excessive but should reflect a reasonable approximation of the anticipated damages at the time of contract formation. 
• Have a Contextual Justification: Include a rationale for the specified amount within the contract. This could involve explaining why this amount is considered a reasonable estimate of damages. For instance, in a service contract, a daily rate for delays can be justified based on average daily expected earnings or costs.
• Clarity and Precision: Draft the clause with clear and unambiguous language. Specify the circumstances under which the liquidated damages will apply, and the method of calculating the damages.
• Review and Update as Necessary: In long-term contracts, consider reviewing and, if necessary, updating the liquidated damages clause to reflect any significant changes in the business environment or the nature of the agreement.

By following these practices, parties can create liquidated damages clauses that provide certainty and clarity in the event of a breach and are more likely to be held enforceable by the courts.

Example: BuildRight Construction signs a contract to complete a new luxury hotel for PrestigeSuites Hotels within 18 months. The timely opening of the hotel is critical for PrestigeSuites to capitalize on the upcoming tourist season. The contract states that for every day past the deadline that the hotel is not ready for opening, BuildRight Construction will pay PrestigeSuites a predetermined sum. This amount is based on PrestigeSuites's projected daily revenue from the hotel operations, factoring in the high tourist season rates. Because it contained a fair and reasonable estimate of lost profits, the court will likely uphold the clause.