The Effective Use of Liquidated Damages Provisions

The Basics of Liquidated Damages Provisions

A liquidated damages provision fixes the amount of money one party will pay to the other if a breach occurs.  Because the law of contracts is designed to be compensatory, however, a payment-for-breach-clause that is penal will not be enforceable (Some reasons for this are discussed in “Why Not Enforce ‘Penalty’ Liquidated Damages Clauses?”).  Accordingly, even if a contract conspicuously says: “If the purchaser is one second late to the closing, it shall pay the seller $10,000,000,” that clause very likely will be deemed to be an unenforceable penalty.

So what makes for a valid liquidated damages provision?  There are two essential conditions:

  1. At the time the contract was executed, it must have been the case that it would have been difficult to determine the damages caused by a breach.
  2. At the time the contract was executed, the amount of the monetary payment designated must have appeared to have been a reasonable estimate of the expected damages for the contemplated breach. 
The Value of Liquidated Damages Provisions and When to Use Them

A key aspect of a valid liquidated damages provision is that it entitles the plaintiff to the agreed upon payment: (a) without ever having to prove its actual damages; and (b) even if it is obvious that no actual damages exist.  Thus, for example, courts have awarded liquidated damages to the seller of real estate where the buyer improperly refused to complete the transaction – even though the seller later sold the property to another buyer for more money.  See Kelly v. Marx.

While some attorneys like to focus on the “windfall” potential of liquidated damages provisions, there are at least two other reasons to use them.

  1. They can act as effective deterrents to ensure that your contractual partners think twice (and maybe three times) before breaching.  While a liquidated damages provision must meet the above requirements, the fact that it also may have a deterrent effect will not invalidate it.  Consequently, if you have an employee under contract and that contract contains a covenant not to compete, including a liquidated damages provision for a violation of the covenant might be just enough added “incentive” to ensure that the employee never challenges the validity of the restrictive covenant.
  2. Having a liquidated damages provision may be the only feasible/practical way for you to obtain damages if a breach occurs.  Imagine, for instance, that you have a contract calling for your company to be the exclusive widget supplier to Widgeco.  If the real value in the contract to your company is being able to advertise to the world that it is Widgeco’s exclusive supplier, it might be impossible to prove how much would be lost if Widgeco were to breach and buy widgets from your biggest competitor.

As these examples show, including appropriate liquidated damages provisions in your contracts can prove to be valuable by both preventing disputes from arising and expediting resolutions in your favor.