A lot of people are curious about liquidated damages. Contracts that involve the exchange of money or the promise of performance have a liquidated damages stipulation. The purpose of this stipulation is to establish a predetermined sum that must be paid if a party fails to perform as promised.
Damages can be liquidated in a contract only if:
- The injury is either uncertain or difficult to quantify.
- The amount is reasonable and considers the actual or anticipated harm caused by the contract breach, the difficulty of proving the loss and the difficulty of finding another adequate remedy.
- The damages are structured to function as damages, not as a penalty. If these criteria are not met, a liquidated damages clause will be void.
A penalty is a sum that is disproportionate to the actual harm. It serves as a punishment or as a deterrent against the breach of contract. Penalties are granted when it is found that the stipulations of a contract have not been met. As an example: a builder who does not meet his schedule may have to pay a penalty.
Liquidated damages on the other hand, are an amount estimated to equal the extent of injury that may occur if the contract is breached. These damages are determined when a contract is drawn up and serve as protection for both parties that have entered into the contract such as buyer and seller, an employer/employee or similar parties.
Liquidated damage clauses possess several contractual advantages. They establish some predictability involving costs so that parties may balance the cost of anticipated performance against cost of a breach. In this way, liquidated damages serve as a source of limited insurance for both parties.
Another contractual advantage of liquidated damages is that the parties each have the opportunity to settle on a sum that is mutually agreeable rather than leaving the decision up to the courts adding the costs of time and legal fees.