What are liquidated damages?

Liquidated damages are presented in some legal contracts as an estimate of otherwise intangible or hard-to-define losses for one of the parties. This is a provision that allows the payment of a specified sum in the event of breach of contract by one of the parties.

Key points to remember

  • Liquidated damages are presented in some legal contracts as an estimate of otherwise intangible or hard-to-define losses for one of the parties.
  • These damages are paid in the event of breach of contract, and are pre-estimated and specified in advance when the contract is signed.
  • Liquidated damages are meant to be a fair representation of losses in situations where actual damages are difficult to determine.
  • Courts generally require the parties involved to make the most reasonable assessment possible of the liquidated damages clause at the time of signing the contract.

Understanding Damages

Liquidated damages are meant to be a fair representation of losses in situations where actual damages are difficult to determine. In general, liquidated damages are designed to be just rather than punitive.

Liquidated damages may be mentioned in a specific contractual clause to cover circumstances where a party suffers a loss of assets that do not have a direct monetary correlation. For example, if a party to a contract were to disclose supply chain pricing information that is vital to a business, it could fall under damages.

Example of liquidated damages

A common example is the design phase of a new product which may involve consulting with external vendors and consultants in addition to a company’s employees. The underlying blueprints or designs of a product may not have a definite market value. This may be true even if the subsequent product is crucial to the progress and growth of a business.

These plans may be considered company trade secrets and highly sensitive. If the plans were revealed by a disgruntled employee or supplier, it could greatly hamper the ability to generate revenue from the release of this product. A company should make an estimate in advance of what these losses might cost in order to include it in a liquidated damages clause of a contract.

Special Considerations

A liquidated damages clause may not be enforced by the courts. This can happen if the monetary amount of damages quoted in the clause is extraordinarily disproportionate to the scope of what was affected by the breached contract.

Such limitations prevent a plaintiff from attempting to claim an unwarranted exorbitant amount from a defendant. For example, a plaintiff might not be able to claim liquidated damages equal to multiples of its gross income if the breach only affected a specific part of its operations.

Courts generally require the parties involved to make the most reasonable assessment possible of the liquidated damages clause at the time of signing the contract. This can provide a sense of understanding and reassurance as to what is at stake if this aspect of the contract is breached. A liquidated damages clause can also give the parties involved a basis for negotiating an out-of-court settlement.

The concept of liquidated damages revolves around compensation for harm and injury to the party, rather than a fine imposed on the defendant.

How does liquidated damages differ from a penalty clause?

Liquidated damages are intended to recover what has been lost and restore the integrity of the injured party. A penalty clause, on the other hand, is intended to be a form of (punitive) punishment.

What are unliquidated damages?

Unliquidated damages are similar to liquidated damages in that they are intended to compensate an injured party for a breach of contract. Unliquidated damages, however, are not pre-estimated in advance when the contract is signed, as is the case with liquidated damages.

What are the types of damage in the legal context?

Where there is a violation of law that harms or injures another party, there are three general types of compensatory damages (paid in money) that the plaintiff may seek and may be awarded by a court:

  • Economic damage to recover money or other financial losses
  • Non-economic damage to repair non-monetary losses such as bodily or emotional damage
  • Punitive damages impose an additional penalty on the culprit
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