If you have ever negotiated a real estate or commercial contract, you’re likely familiar with the term “liquidated damages.” Liquidated damages are, in short, a sum that a party agrees to pay in the event he breaches a contract. Stated differently, the parties can agree up front how much the breaching party will owe the non-breaching party if their contractual relationship goes awry.
You have likely seen liquidated damages clauses in the following contexts:
- Real estate purchase and sale contracts: The earnest money deposit, which parties negotiate as a sole remedy in the event a buyer backs out of the agreement, is a liquidated damages provision.
- Residential or commercial construction contracts: The parties may agree that if one party delays, he will owe the non-breaching party a sum of money for each day of the delay. This sum typically represents the best estimate of the profits the non-breaching party lost as a result of the breaching party’s delay.
- A lease agreement: A landlord may require a tenant to pay a certain amount if he breaches the lease agreement.
A liquidated damages clause must be clearly specified in a contract and reflect a reasonable estimate of the likely damages that the non-breaching party would incur. In determining whether a clause is enforceable, courts generally consider the following factors, among others:
- Whether the damages the parties reasonably anticipate are hard to ascertain due to their indefiniteness or uncertainty;
- Whether the amount of damages represents a reasonable estimate of the damage or is reasonably proportionate to the damages actually incurred;
- Whether the amount is so large that it functions more like a penalty to the breaching party than compensation to the non-breaching party; and
- Whether the goods or services at issue have a clear, easily ascertainable market value.
The party who is found liable carries the burden of proving the reasonableness of a liquidated damages clause. When damages are harder to prove or ascertain, it is more likely that a court will find that a clause was reasonable and thus enforceable.
Benefits of Liquidated Damages Clauses
The primary benefit of a liquidated damages clause is that it helps parties sidestep expensive litigation – especially the often protracted damages portion of a trial. Further, many commercial cases, especially construction disputes, are expensive due to the extensive discovery that is often involved.
A liquidated damages clause can protect contractors from the risk of lost profits. For example, imagine a developer contracts with a builder for a mixed-use condominium project. There is a set timeline for the work, and once all subcontractors are engaged, the work commences. Then, one of the subcontractors unexpectedly – and without explanation – stops work. Meanwhile, various tenants are signing leases for the commercial and residential properties, expecting them to be finished at a particular time. But because the project is delayed and thus unfinished, the new tenants are unable to move in. The non-breaching party – the contractor – loses money as tenants walk away. In this case, a preset damages clause can provide a clear remedy without forcing the aggrieved contractor to file a lawsuit to collect its lost profits. Not to mention, it will save the parties from heated negotiations and arguments about what measure of damages is appropriate to compensate the contractor.
In the process of drafting a liquidated damages clause, the parties can compare and weigh the value of a contract against the costs of a potential breach, helping them evaluate risk and determine whether a contract makes economic sense. In some cases, parties may determine that the likely cost a breach to one party would seriously outweigh the benefits of completing the project, thus effectively avoiding a potentially costly situation.
Potential Detriments of Liquidated Damages Clauses
Liquidated damages clauses are often litigated in and of themselves – defeating the purpose of saving costly, time-consuming litigation. In fact, liquidated damages clauses are not automatically deemed enforceable. They must be reasonable, made in good faith, and not so large that they function more like penalties than compensation for the non-breaching party. In the construction context, the issue of concurrent delays can further muddy the waters. For instance, when a subcontractor delays a project by failing to deliver or install the proper equipment for the job, but the contractor is also behind, it can be difficult to determine the cause of the delay and properly apportion damages without diving into litigation.
Additionally, parties may not be able to anticipate the amount of damages before they embark on a project. For instance, the parties to a real estate contract take a risk when negotiating an earnest money deposit, as they are making a reasonable estimate of an amount that will protect them in the event the contract falls through. Similarly, parties to a construction contract may find it difficult to adequately capture their expected profits before they commence work on a project.
Finally, a pre-set damages amount deprives parties of the opportunity to let a neutral, impartial judge or jury determine an amount of damages. In deciding on a pre-set damages amount, parties increase the risk that they may not be compensated as fully as they would like to be.
What Parties Can Consider When Drafting a Liquidated Damages Clause
Each contract is unique and as such, boilerplate damages clauses will not provide adequate protection. It is critical to contact an experienced attorney if you are attempting to draft a contract with a liquidated damages clause. However, generally, there are several factors to consider when determining the nature and amount of a liquidated damages clause in a contract:
- The nature of the contract (e.g., whether it is a contract for goods or services);
- The possible deterrent effect of a liquidated damages clause;
- The term of the contract;
- The various factors that may affect whether the contract can be fully performed;
- The feasibility of determining a specific amount of damages; and
- The overall reasonableness of the amount of damages given the totality of the circumstances.
If you have questions about the enforceability of a liquidated damages clause in your commercial contract, or you think you have a viable claim for its enforcement, contact us for a consultation.
This article does not establish an attorney-client relationship and is not to be construed as legal advice.