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:
- 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.
- 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.