A breach of contract may be obvious. It’s easy to tell when a contractor on a building project has not achieved practical completion on time. The hard part is figuring out how much the breaching contractor must pay in damages. This bit tends to get murky. Parties can spend a lot of time, money, and effort arguing over the measurement of damages. That’s why the law allows parties to include liquidated damages clauses in contracts.
The word ‘liquidate’ comes from the Latin word ‘liquidare,’ which means to melt or make clear. Parties can use a liquidated damages clause to make clear the murky process of calculating damages in the event of a particular type of breach. Both parties benefit in knowing how much a breach is going to cost.
By way of example, a liquidated damages provision may provide that if a building contractor breaches by not reaching practical completion by a certain date, the contractor will be required to pay a predetermined amount as damages for each day the party remains in breach until a cap is reached. This may be a set dollar amount or derived from a formula.
When thoughtfully negotiated, liquidated damages can go a long way to add predictability and motivate the other party to avoid breaching the contract. When damages, of a known amount accrue daily, the breaching party will go to great lengths to timely perform their obligations.
If unskillfully negotiated, liquidated damages provisions are worthless. This is because courts will only enforce these provisions if they state an amount that is reasonable in light of the anticipated or actual loss caused by a particular type of breach and the difficulties of proof of loss.
Courts can only dish out penalties in limited circumstances. A term fixing unreasonably large liquidated damages will be viewed as a punishment. The court will scrap the unreasonably high liquidated damages clause as invalid and dive back into the murky water of determining damages based on evidence.
To enforce a liquidated damage provision the court must be convinced of two things: First, at the time of negotiation, the damages likely to be incurred because of a breach are uncertain or difficult to estimate, and second, the amount is reasonable and not a penalty.
One obvious way to bolster the argument that damages are difficult to estimate and not a penalty is to say it in the contract. Consider language such as: “The Parties acknowledge and agree that the amount of loss or damages likely to be incurred by Company as a result of failure of Contractor to achieve practical completion of the Work on time is difficult or impossible to precisely estimate. The parties further acknowledge and agree that these Liquidated Damages represent a genuine pre-estimate of the damages likely to be suffered by Company and such Liquidated Damages will not be construed as a penalty.”
Keep in mind, however, that this language alone does not guarantee the court will view the liquidated damages as a genuine estimate of damages rather than a punishment. Language asserting the reasonableness of the clause, coupled with an unreasonably high value, will look like lipstick on a pig.
Also, its useful to include explanation of how the estimate was calculated. Worksheets and notes can also be referenced in the contract and attached as an exhibit.
While a party may be tempted to insert large liquidated damages clauses in a contract as a way of guaranteeing performance, courts will quickly cast aside the provision if not thoughtfully crafted as a genuine estimate of anticipated damages. Your goal in negotiating a liquidated damages clause is to avoid the murky and uncertain waters of proving damages. To that end, don’t get greedy and keep it real.
Lead Attorney & Owner
InSource Law LLC