Liquidated Damages

Monetary compensation for a loss, detriment, or injury to a person or a person's rights or property, awarded by a court judgment or by a contract stipulation regarding breach of contract.

Generally, 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 (1) the injury is either "uncertain" or "difficult to quantify"; (2) 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; and (3) 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.

The American Law Reports annotation on liquidated damages states, "Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in light of the anticipated or actual harm caused by the breach. … A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty" (12 A.L.R. 4th 891, 899).

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 a contract. Penalties are granted when it is found that the stipulations of a contract have not been met. For example, a builder who does not meet his or her 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 the contract, whether they are a buyer and a seller, an employer and an employee or other similar parties.

The principle of requiring payments to represent damages rather than penalties goes back to the EQUITY courts, where its purpose was to protect parties from making UNCONSCIONABLE bargains or overreaching their boundaries. Today section 2-718(1) of the UNIFORM COMMERCIAL CODE deals with the difference between a valid liquidated damages clause and an invalid penalty clause.

Liquidated damages clauses possess several contractual advantages. First, they establish some predictability involving costs, so that parties can balance the cost of anticipated performance against the 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 clauses is that the parties each have the opportunity to settle on a sum that is mutually agreeable, rather than leaving that decision up to the courts and adding the costs of time and legal fees.

Liquidated damages clauses are commonly used in real estate contracts. For buyers, liquidated damage clauses limit their loss if they default. For sellers, they provide a preset amount, usually the buyer's deposit money, in a timely manner if the buyer defaults.

The use and enforcement of liquidated damages clauses have changed over the years. For example, cases such as Colonial at Lynnfield v. Sloan, 870 F.2d 761 (1st Cir. 1989), and Shapiro v. Grinspoon, 27 Mass. App. Ct. 596, 541 N. E. 2d 359, 1989), have granted courts permission to compare the amount set forth in the liquidated damages provision against the actual damages caused by a breach of contract. These "second-look" rulings have led several courts to honor the liquidated damages clauses only if they are equal to, or almost equal to, the actual damages.