Liquidated Damages

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.

Liquidated Damages

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.
  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.

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.

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