Liquidated Damages Clauses in Contracts
January 15, 2015
As a business owner or manager, you deal with a variety of contracts on a daily basis. With so many different types of clauses and terminology, contracts can easily become complicated and cumbersome. Even if you use a legal professional to help draft and review contracts, you still need to personally understand what your contractual obligations are, since your business will ultimately be held responsible.
Liquidated damages (LDs) clauses are a popular and practical way to deal with the possibility of contract breaches between businesses. LDs clauses are common in many different types of contracts, including commercial construction and engineering contracts, sale or supply of goods contracts, IT development contracts and more. However, just inserting any sample LDs clause in a contract is not enough—businesses need to ensure that the clause is properly considered, accurately written and enforceable by the courts.
What are Liquidated Damages Clauses?
A LDs clause in commercial contracts establishes that if a party breaches a particular obligation under the contract, then they must pay a specified sum of money to the other party as compensation for that breach. The sum payable for the breach is fixed, agreed to by both parties and written into the contract.
There are several benefits to using LDs clauses in your contracts, including:
- The sum specified is payable as soon as the breach occurs. This removes the extensive amount of time and costs it takes for an injured party to bring an action for damages.
- There is no requirement for an injured party to mitigate damages as there is with an ordinary breach of contract claim.
- An injured party simply needs to show that a relevant breach occurred and does not need to prove that he or she has suffered a loss as a result.
- The amount recoverable is already set and not subject to a court’s decision. This brings a greater degree of certainty regarding the contract—parties already know how much they will recover (or pay) if a certain breach occurs.
- Parties can preserve their commercial relationship. In certain situations, once the breaching party pays the LDs, both parties can continue performing the rest of the contact, without having to go through the process of initiating legal action.
Make Sure Your Liquidated Damages Clause is Not a Penalty
While LDs clauses have many benefits, in order to utilise these benefits, you must make sure that your LDs clause is enforceable. While courts typically uphold provisions in commercial contracts that have been freely entered into by both parties with similar bargaining powers, they will likely not enforce any agreements that are considered a ‘penalty’ or punitive in nature. Therefore, as long as the court finds that your LDs clause is indeed a LDs clause and not a penalty clause, it will likely be enforceable.
The courts will look at several principles when determining whether a LDs clause is considered a penalty clause or not, including:
- Purpose. The purpose of the LDs clause is crucial and must be to compensate the injured party for losses due to a breach, not to coerce or apply undue force on a party to perform the contract. The clause must also serve a legitimate commercial purpose.
- Extravagant and Unconscionable Sum Specified. The sum specified in the LDs clause must be a genuine pre-estimate of the anticipated loss and cannot be ‘extravagant and unconscionable’. However, the sum specified in the contract does not have to match the actual loss suffered and courts typically allow a generous margin for error.
- Serious and Trivial Breaches Distinction. Parties should agree to different sums specified regarding different types of breach. Smaller and more trivial breaches should have a lower sum specified while larger and more serious breaches should have a higher sum specified. If there is a single sum specified for both trivial and serious breaches, the court will likely presume it is a penalty clause.
- Payment Obligation Breaches. If the breach in question is for not paying a particular sum of money and the sum specified in the LDs clause is greater than what should have been paid originally to fulfil the contract, then courts will presume it is a penalty.
This list is not exhaustive and the court may look at additional factors and elements.
Hints and Tips for Drafting a Proper Liquidated Damages Clause
Consider the following tips when drafting your LDs clause to help ensure that it will not be considered a penalty.
- Make sure that you carefully choose your LDs sums specified. The sums specified should be a genuine pre-estimate of anticipated losses. If quantifying a sum specified is difficult, adopt a procedure that justifies any figures chosen. Keep written records on what calculations were used and why a particular sum specified was selected.
- Make sure that the sum specified for payment obligation breaches is not much greater than what would have been originally paid to fulfil the contract.
- Make sure to distinguish between serious and trivial breaches, each with LDs sums specified amounts that correlate to the severity of the breach.
- Create separate sub-clauses where different sums are to be paid for separate breaches. Insert a severance clause into the contract to help ensure that if certain provisions are held to be unenforceable, the remainder of the contract can still be enforced.
- Include wording in the contract stating that the parties agree that the sums specified are a genuine pre-estimate of anticipated losses and not a penalty. This does not guarantee that courts will enforce a LDs clause, but it is persuasive.
- Make sure that the LDs clause (and entire contract) is properly vetted and reviewed by an appropriate legal professional.