What are liquidated damages?
The victim of a breach of contract, in many circumstances, is entitled to recover damages caused by the breaching party. Determining the proper amount of damages can be a difficult and expensive exercise. For that reason, the law allows the parties to a contract to agree, ahead of time, what the damages will be in the event of a breach. These are called “liquidated damages.” They are sums that contracting parties agree to pay as damages, if they fail to perform under the contract.
As an example, an employee might agree to a non-solicitation agreement, under which, the employee agrees that, in the event he or she leaves the current job, he or she will not solicit the company’s customers. In the event the employee breaches the contract, he or she agrees to pay X amount of dollars in damages for every act of solicitation. These would be liquidated damages.
Liquidated damages are not always enforceable however. As a general rule, a court will not enforce a liquidated damages provision that amounts to nothing more than a mere penalty for violating the contract. The purpose of liquidated damages is not to allow parties to impose penalties upon one another. The purpose is to allow them to save time and money by agreeing, ahead of time, to good faith and reasonable estimates of likely damages in the event of a breach.
To determine whether the provision constitutes an unlawful penalty, courts look to several factors, including:
- the intent of the parties in entering into the contract;
- whether the agreed amount is reasonable and bears some relationship to the actual damages suffered;
- whether the agreed amount is disproportionate to the actual damages suffered; and
- whether the actual damages are difficult to ascertain.
If the liquidated damages provision is construed as a penalty, it may not be enforceable.
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