What are Liquidated Damages and When are they Enforceable?

Many contracts contain a “liquidated damages” clause, under which the parties agree, at the time they sign the contract, to a pre-determined amount of damages, or a calculation to determine damages, in the event a party breaches the contract down the road.  Liquidated damages can be helpful because they can deter a breach as well as provide certainty to the parties about the financial consequences of a breach.  They are used in a wide variety of contracts, particularly where it may be difficult to calculate damages, such as construction projects, leases and other contracts concerning real estate.  

Liquidated damages clauses, however, are not automatically enforceable.  Courts routinely refuse to enforce them when they are so disproportionate to anticipated damages as to constitute a “penalty.”  Determining whether the provision is a “penalty” can be tricky because the court must conduct the proportionality assessment based on the circumstances existing at the time of the contract.  An important factor is whether the damages are difficult to ascertain at the beginning of the contract.  If damages are not easily ascertainable, the liquidated damages provision will be enforced as long as it was a reasonable forecast of expected damages.  If the damages at the time of contract are easily ascertainable (such as when they are based on lost profits), the court may take a closer look and not enforce it if the liquidated damages (the estimate) is grossly disproportionate to the actual damages or is unconscionably excessive. 

These are important provisions that businesses and practitioners should not gloss over when negotiating contracts. 

-By David Mack