If your business finds itself frequently entering into commercial contracts, chances are you have unknowingly agreed to a “liquidated damages” provision. While these provisions work in certain scenarios and may sometimes be in your best interest, the reverse is often true as well. Businesses should be mindful of a few considerations when reviewing a commercial contract that contains a liquidated damages provision.
What Are Liquidated Damages?
Liquidated damages provisions try to predict the future if things go wrong under an agreement. These clauses provide an estimate, made by the parties at the time they enter into their agreement, of the extent of the injury that would be sustained as a result of breach of the agreement. They are typically included in contracts where it would be difficult or impossible to calculate the amount of actual damage if the contract were breached. They need not be reciprocal and are ultimately dependent on how the parties allocate risk to one another. A typical liquidated damages provision looks like this:
If Seller fails to deliver the Products by the Delivery Date (the “Seller Breach”), Seller shall pay to Customer an amount equal to x% of the Purchase Price of the Products for each day a Seller Breach continues (the “Liquidated Damages”). The parties intend that the Liquidated Damages constitute compensation, and not a penalty. The parties acknowledge and agree that Customer’s harm caused by a Seller Breach would be impossible or very difficult to accurately estimate at the time of contract, and that the Liquidated Damages are a reasonable estimate of the anticipated or actual harm that might arise from a Seller Breach. Seller’s payment of the Liquidated Damages is Seller’s sole liability and entire obligation and Customer’s exclusive remedy for any Seller Breach.
A liquidated damages provision often serves as the exclusive compensation for the breaching party’s failure to perform a specific task or comply with a particular obligation, such as a breach of representation or a breach of covenant. The provision requires the breaching party to pay the non-breaching party either (i) a predetermined fixed amount (or cap on amounts) or (ii) an amount based on a predetermined formula.
Generally speaking, liquidated damages provisions are enforceable if the following three conditions are met:
If you encounter a liquidated damages provision, there are a few important things to be mindful of:
1. Jurisdiction Matters Liquidated damages provisions receive different treatment depending on the jurisdiction. In this regard, it is critical to understand the governing law of the jurisdiction at issue before drafting the liquid damages provision. Some commercial agreements include optional liquidated damages provisions. These are not always enforceable depending upon state law.
2. Not All Damages are Created Equal The parties need to have a clear understanding as to the definition of the types of damages that could be at issue in their agreement:
3. No Penalties Allowed
It is important not to overreach with respect to drafting a liquidated damages provision and risk a determination that the provision is unconscionable or against public policy. If the amount of liquidated damages is so severe that it is perceived by a court to be a penalty, it will not be enforceable. Parties to an agreement should consider adding language to the effect of “the parties intend that the liquidated damages constitute compensation, and not a penalty.”
4. Show Your Math To be enforceable, liquidated damages must be a reasonably proportional approximation of actual damages. In litigation, a breaching party will often contend that this condition was not satisfied. Courts will typically consider what was reasonable at the time the contract was entered into as opposed to when the breach occurred. Thus, parties should consider including the rationale and/or formula of how liquidated damages were calculated in the actual liquidated damages provision itself. While this will not guarantee the provision is ultimately held enforceable, it will weaken the breached party’s argument that the provision was not reasonable at the time of contracting.
5. Read the Entire Agreement A liquidated damages provision must be evaluated in light of the entire agreement, as it may conflict with other contractual provisions contained therein. For example, businesses should ensure that the liquidated damages provision is consistent with any cumulative remedies provision, as parties typically agree to liquidate damages as an exclusive remedy in lieu of the right to pursue cumulative remedies, including actual damage.
Matthew C. Cooper is an attorney in MacElree Harvey’s Business Department specializing in business and corporate law. He counsels businesses of various sizes and industries through all stages of the business life cycle, including representing management and boards of directors by helping them stay compliant with the ever-changing landscape of corporate law. Matthew frequently represents businesses in private financings, and is a trusted adviser to lenders and borrowers in commercial lending transactions. If you have any corporate or business law needs, please contact Matthew C. Cooper at (610) 840-0279 or firstname.lastname@example.org.