A contract contains pages of promises, deadlines and obligations. But what happens when they are breached? Liquidated damages are there to make the result unambiguous. As Lord Leggatt opined, liquidated damages “substitute the certainty of a contractually agreed sum for the uncertainty of an assessment of damages by a court.” [2021] UKSC 29.
- What are liquidated damages?
“Liquidated” means fixed, settled, or void of uncertainty. Liquidated damages are specified in a contract—they are not hard to crack or inscrutable. The party receiving performance can ask for fixed damages in the event that the performing party fails to perform.
This is where liquidated damages come in. Rather than wrangling over how much a breach hurts the non-breaching party—and spending time and attorneys’ fees to find out—the parties can simply look to the contract to determine the damages. In a perfect world, liquidated damages (or LDs) reduce contracting uncertainty in contracting. The U.S. Supreme Court has recognized the purpose behind these clauses, noting that they are useful when damages are uncertain or difficult to measure.
- Why would a contract need LDs?
LDs don’t make sense in every contract, legally or practically. However, they are particularly helpful in certain situations. Imagine a construction company agrees to complete a project for a developer by June 1, 2026. A delay may cause the owner to lose rental income, pay additional employees, arrange temporary facilities, or face other business disruptions. But how much would a delay cost? Reasonable minds could differ.
The parties therefore might agree that the contractor would pay $5,000/day in the event of a delay. This amount would be intended as liquidated damages, meaning that the parties would agree in advance that this amount would be reasonable compensation for a delay. Rather than paying experts to provide competing models for how much was lost for a day of delay, the parties could simply look at the agreed amount. They would benefit: the developer would be compensated and the construction company would have certainty on expected damages.
The parties might therefore agree that the contractor will pay $5,000 for each day of delay. That amount is intended to be liquidated damages, meaning the parties have agreed beforehand on a reasonable measure of the expected loss. This can make a future dispute much easier because the parties do not have to start from zero when calculating damages. As the Federal Circuit explained, liquidated damages can “save the time and expense of litigating the issue of damages.” DJ Manufacturing Corp. v. United States, 86 F.3d 1130 (Fed. Cir. 1996),
- Liquidated Damages Vs Penalty
Liquidated damages, however, are not a panacea. They cannot function as a penalty. A penalty is an amount included in a contract mainly to punish the breaching party, rather than reasonably compensate the other party for its expected loss.
Courts generally distinguish between the two. A reasonable liquidated damages clause may be enforceable, while an unreasonably large amount may be treated as an unenforceable penalty. The Restatement approach and U.S. case law focus heavily on reasonableness and the difficulty of estimating the loss. As Judge Richard Posner stated: “[i]f it is plain from the beginning that the specification is designed to give the victim of the breach much more than he could expect actually to lose…then it is a penalty clause.” Richard A. Posner, Economic Analysis of Law 128 (3d ed. 1986).
How do courts decide? They look to reasonableness. If a contract says that a one-day delay will result in $2,000 in damages, there may be a reasonable basis for that amount. By contrast, if the same contract imposes $1 million for the same delay—without any reasonable connection to the expected loss—it looks more like punishment than a pre-estimate of losses.
The label used in the contract is not decisive. Calling a clause “liquidated damages” does not automatically make it enforceable. Courts look to the substance to determine whether it is a penalty.
- How do Courts Decide Whether the clause is enforceable?
There is no magic number or formula. Rather, courts generally look to the following factors:
- Was the potential loss difficult to estimate when the contract was made?
- Was the agreed amount a reasonable estimate of the expected loss?
- Does the amount have a reasonable relationship to the harm caused by the breach?
In Wassenaar v. Panos, 331 N.W.2d 357 (1983), the Wisconsin Supreme Court discussed these factors and emphasized whether the injury was difficult to estimate and whether the agreed amount was a reasonable forecast of the harm. In Watson v. Ingram, 124 Wash. 2d 845, 855 (1994), the Washington Supreme Court found that the “parties could not know what delays might ensue, what might occur in the real estate market, or how a failed sale might affect the seller’s plans.” These questions capture the basic idea. The parties are allowed to estimate, but they generally cannot use the contract simply to impose an excessive punishment.
- Why should lawyers pay attention to this clause?
Liquidated damages matter for several key reasons. First, by clarifying the amount to be paid in the event of a breach, they shift risk from the non-performing party onto the performing party. Second, in order for that risk shift to actually work, the amount must be a reasonable pre-estimate of damages—not a penalty. Third, a liquidated damages clause greatly shifts the damages portion of any litigation (or arbitration) that results from a breach of contract.
All of this makes good lawyering essential. Lawyers drafting or negotiating contracts must ensure that operative conditions for liquidated damages provisions are clean and unambiguous. If any grace period, condition precedent, or exceptions apply, they should be specified clearly so as to avoid uncertainty. Second, the amount of any liquidated damages must be a genuine pre-estimate of losses and not a penalty. This may occasionally fall outside of lawyers’ wheelhouses, but, as with Justice Potter’s quip on pornography, you’ll often know when you see it. LDs grossly disproportionate to the actual loss or arbitrary amounts that are not tied to a particular situation are more likely to be deemed penalties. One should ask oneself: is this reasonable?
- Getting the details right
The exact rules can vary depending on the state, type of contract and other circumstances. This is why the LD clause should not be treated at arbitrary or ordinary boilerplate. They should be subject to “fair and reasonable attempts,” as the Supreme Court articulated in Priebe & Sons, Inc. v. United States (332 U.S. 407, 1947), to establish compensation for anticipated loss.
Next time you come across a liquidated damages provision in a contract, don’t skip it. Understand the breach it covers, whether there are any conditions precedent, and what exceptions, if any, apply to it. Most importantly, interrogate the amount. For as Justice Holmes states: “The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it—and nothing else.”
Disclaimer: This blog is for informational purposes only and does not constitute legal advice. Reading or interacting with this content does not create an attorney–client relationship. You should consult a qualified attorney for advice regarding your specific situation. Mehaffy, PLLC disclaims all liability for actions taken or not taken based on this blog.