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What Are Liquidated Damages?

By Aditi Mukherji, JD | Last updated on

If you're signing a contract, it may contain a liquidated damages clause. But what exactly are liquidated damages?

It's not just social media pariahs like Amy's Baking Company who have to deal with liquidated damages in contracts. More often than not, contracts that involve the exchange of money or the promise of performance have a liquidated damages stipulation.

But depending on how a liquidated damages clause is written, it can potentially be challenged in court.

In Case of Contract Breach

A liquidated damages clause sets an amount in a contract in the event of a breach. Think of it as "contract performance insurance."

A liquidated damages clause isn't a penalty, though it may sound like one. A penalty is usually disproportionate to the actual harm, and is meant to punish or deter breaching a contract.

Liquidated damages, however, serve as protection for both parties that have entered the contract: buyers and sellers, employers and employees, and so on.

But here's the catch: Liquidated damages must be a reasonable estimate of actual damages that may result from a breach.

When Are Liquidated Damages Appropriate?

Damages can be liquidated in a contract only if:

  • The injury is either "uncertain" or "difficult to quantify";
  • The amount is reasonable and considers the actual or anticipated harm caused by the contract breach;
  • The loss is difficult to prove;
  • There isn't really a better alternative remedy another; and
  • The damages are structured to function as damages, not as a penalty.

People like to include liquidated damage clauses in contracts because they establish predictability involving costs. It lets two parties balance the cost of anticipated performance against the cost of a breach -- just like how limited insurance works.

Another advantage is that a liquidated damages clause lets both parties settle on a sum that they can mutually agree upon, rather than leaving the decision up to the courts in costly litigation.

Liquidated damages clauses are common in real estate contracts. For buyers, liquidated damage clauses limit their loss if they default. For sellers, they provide a preset amount, usually the buyer's deposit money, in a timely manner if the buyer defaults.

You don't have to be a celebrity like Justin Bieber to use a liquidated damages provision. But if you have questions about whether a liquidated damages clause is valid, you may want to consult an experienced contracts lawyer near you.

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