What is liquidated damage?

Liquidated damages are a variety of damages that may be used in the context where damages incurred are real but often difficult or impossible to prove. They normally contain a provision that specifies a predetermined amount of money that one party must pay if the terms of the contract are breached. This predetermined amount is normally calculated by parties to the contract estimating the number of damages that a hypothetical breach of contract would cost. In the event of a breach with a liquidated damages clause, parties do not need to prove or calculate the actual damage incurred. Instead, the breaching party would pay out the predetermined sum outlined in the liquidated damages clause. However, if the clause is grossly disproportionate to the commercial agreement, this too can also affect how the provision can be enforced. Nonetheless, it is important to control the liquidated damage clause when reviewing a contract. For example, to ensure it is covered by insurance.

 

A liquidated damage provision will be enforced when…

 

This can differ according to the laws by which the contract is governed. However, a rule of thumb is the following.

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Liquidated damage provisions will be enforceable when:

 

• Damages are difficult to get a clear estimation of

A court will likely enforce a liquidated damages clause if the nature of the damages is difficult to estimate. Topics such as breach of a confidentiality agreement, trade secrets, intellectual property, all of these, and more could be topics that are unclear or difficult to get a clear number on when it comes to damages.

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•    The amount in the liquidated damage clause is reasonable and not a penalty

A liquidated damages clause is more likely to be enforceable if the damages are proportionate to the breach that it is meant to compensate. In contrast, if the liquidated damage clause is more similar to a penalty or punishment, it is less likely to be enforced. This assessment may be made in the context of what was reasonable at the time of the creation and signing of the commercial agreement.

How is liquidated damage calculated?

Liquidated damages are calculated and utilized when it is difficult to set an amount on the damage caused. Generally, the nature of damages in which the liquidated damage clause deals is difficult to set an amount on, and therefore, a liquidated damage clause needs to be used. General practice states that each party to the contract should outline the amount a breach would cost them and negotiate where the fair amount lies between the parties. Depending on the type of contract (Service, NDA, etc.), this will determine the standards under which it may be viewed. The amounts that are drawn out should reflect a reasonable attempt to recoup losses and instead, not be a punitive fee. Make sure you find the liquidated damage to be reasonable when reviewing a contract.

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When to use liquidated damage

Situations in which liquidated damages may be expected often appear in contracts such as the following cases.

IT Development contracts

Liquidated damages may be utilized in these contracts when completion of the commercial agreement is delayed due to the fault of a party’s breach. In this instance, the breaching party will be liable to pay the other party a specified sum over a period as outlined in the contract. The frequency of the payment may be each day, week, or month during which the delay continues on. 

 

Construction contracts

 

Similar to IT development contracts, construction contracts will often use liquidated damages in the instances of delayed deadlines as stipulated within the contract between parties. Depending on the contract, the specified sum outlined by the liquidated damages clause will be liable to be paid each day, week, or month depending on what is stipulated within the contract.

 

Employment contracts

 

Liquidated damages may also be found in employment contracts even though in the past it has been stated that it was unusual to find such a clause within these contracts. Liquidated damages nowadays may come in the form of exposing trade secrets, industry practices, etc.

 

Non-Disclosure Agreements (NDAs)

 

Liquidated damages are commonplace within NDAs as before commercial agreements are entered into, there is often an exchange of information through negotiation of commercial matters. This discussion may include aspects that are difficult to set a price or value on such as the disclosure of intellectual property, trade secrets, or sensitive information. In these cases, liquidated damages are typically used in order to recoup damages of these more difficult types of breaches to establish and quantify. 

Liquidated damage vs unliquidated

Liquidated damages are those payable for a breach of contract by one of the parties and are stipulated before the conclusion of the contract. In contrast, unliquidated damages are those arising from a party’s breach that has not been pre-estimated and, therefore, is granted on the basis of an assessment of the loss and the breach of the contract. These damages may be unforeseeable.

Similar to liquidated damages, for an unliquidated damages clause to be established, there must be a breach of contract. In most cases, for unliquidated damages, there must also be proof of damage or loss that is established to connect the right to receive compensation for the loss incurred.

 

The principles of unliquidated damages may attempt to balance factors such as: 

• That the parties should be returned to the position that they were in, before the breach;

• That the damages awarded should not reflect a penalty;

• A balance must be struck between compensating for the breach and turning it into a punitive act.

 

A clause for unliquidated damages may be a huge advantage as it can help a party recover certain losses that were unforeseeable or difficult to calculate. This can potentially be a disadvantage. However, because the parties to the contract may not want to expose themselves to unknown liability, this could be a difficult clause to negotiate. Possible disadvantages for the party enforcing an unliquidated damages clause are that they may have to prove that a loss occurred, that the loss was a result of the breach of the contract, and that it was not too remote.

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Liquidated damage versus penalty

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A penalty clause is a contractual clause that enforces one party to pay an agreed amount of money if there is a breach of contract that was stipulated in the agreement. The key distinction between a penalty clause and a liquidated damage clause is that the penalty clause is formulated to be a punishment for a breach of contract while the liquidated damage clause is intended to provide compensation.

For a clause to be classified as a penalty clause, the amount of money that is payable must be excessive and disproportionate to the actual loss incurred. This excessiveness in light of the breach will determine whether it is classified as a penalty clause.

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Liquidated damage vs indemnity

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Indemnity and liquidated damages are closely connected, as both are clauses that arise from a loss. Indemnity clauses can be described as security or protection clauses written into contracts in order to protect and enforce certain parties to cover losses incurred. The interpretation of indemnity clauses can be drafted to cover specific situations or be written to have a wider interpretation.

The largest difference between liquidated damages and indemnities is that the indemnity can only be claimed if the loss stemmed from the actions of a third party to the contract. In contrast, liquidated damage clauses can only be claimed through the actions of those who are parties to the contract and have breached the agreement.

 

Liquidated damage vs consequential loss

 

Liquidated damage and consequential loss often get mixed up and over complicated. To simplify, liquidated damage clauses are a type of consequential damage that has been quantified and which specific cost amount to the breach has been measured. The consequential loss itself often refers to damages that arise from special circumstances that were foreseeable. A consequential loss is the non-immediate result of something a party knew or should have known, meaning it could have been prevented. Review this carefully.

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Liquidated damage for delay

 

Commonplace in contracts such as construction or production-related contracts is that they include liquidated damages for delay clauses that are often used to protect against possible losses arising from a delay. This is often stipulated within the commercial agreement to protect parties but could also be useful for the breaching party to address and account for these costs ahead of time. In the process of reviewing and negotiating liquidated damages for delay, all parties should discuss a daily rate that the liquidated damages should cost and address how the daily rate was estimated. Without evidence of how the liquidated damage for the delay is calculated, the sum stipulated within the contract could be deemed as unenforceable. Early completion bonus clauses may also be written into the contract as a reward that incentivizes early deliveries and can make the liquidated damages clause more acceptable.