As suggested in “The Effective Use of Liquidated Damages Provisions,” there can be a fine line between an enforceable liquidated damages provision and an unenforceable penalty clause. Thus, when drafting an agreement, it is important to keep in mind that a payment-for-breach provision will only be enforceable if, at the time of drafting:
- It would be difficult to determine the damages that would be caused if the contemplated breach were to occur; and
- The amount of the of the liquidated damages is a reasonable estimate of the actual damages that your company would suffer if there were a breach.
In light of these overarching principles, be sure that the contract expressly states that:
- All parties agree that if a breach were to occur, it would be difficult to determine actual damages;
- Based on what the parties presently know (include specifics if you can), they agree that $X is a reasonable estimate of the damages that would accrue if a breach occurred in the future; and
- All parties agree that the amount of liquidated damages is fair and reasonable and would not act as a penalty to the breaching party.
Also, consider documenting how you determined your estimate of the damages (assuming this will justify your position that you have come to a reasonable estimate) and include this in the contract as well.
While you might be tempted to err on the high side in terms of the amount of the liquidated payment, this can be a risky strategy because courts will not reform/reduce a liquidated damages clause if the amount exceeds what a reasonable estimate of the expected damages would have been at the time the contract was made. Rather, the Court will strike the entire liquidated damages provision and require the plaintiff to prove its actual damages. Moreover, if damages truly are difficult to prove, having your liquidated damages clause stricken could end up putting your company in a position where it cannot prove any damages and be left with no remedy for the breach.
Taking these steps will make it easier to convince a court that a contractual provision calling for payment in the event of breach is a bona fide liquidated damages provision, and not an unenforceable penalty clause.