What Are Liquidated Damages?

What Are Liquidated Damages?

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

Key Takeaways

  • Liquidated damages are presented in certain legal contracts as an estimate of otherwise intangible or hard-to-define losses to one of the parties.
  • These damages are paid out in the case of a breach of contract, and are pre-estimated and spelled out in advance when the contract is signed.
  • Liquidated damages are meant as a fair representation of losses in situations where actual damages are difficult to ascertain.
  • The courts typically require that the parties involved make the most reasonable assessment possible for the liquidated damages clause at the time the contract is signed.

Understanding Liquidated Damages

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

Liquidated damages may be referred to in a specific contract clause to cover circumstances where a party faces a loss from assets that do not have a direct monetary correlation. For instance, if a party in a contract were to leak supply chain pricing information that is vital to a business, this could fall under liquidated damages.

Example of Liquidated Damages

A common example is a design phase for a new product that may involve consultation with outside suppliers and consultants in addition to a company's employees. The underlying plans or designs for a product might not have a set market value. This may be true even if the subsequent product is crucial to the progress and growth of a company.

These plans may be deemed to be trade secrets of the business and highly sensitive. If the plans were exposed by a disgruntled employee or supplier, it could greatly hamper the ability to generate revenue from the release of that product. A company would have to make an estimation in advance of what such losses could cost in order to include this in a liquidated damages clause of a contract.

Special Considerations

It is possible that a liquidated damages clause might not be enforced by the courts. This can occur if the monetary amount of liquidated damages cited in the clause is extraordinarily disproportional to the scope of what was affected by the breached contract.

Such limitations prevent a plaintiff from attempting to claim an unsubstantiated exorbitant amount from a defendant. For instance, a plaintiff might not be able to claim liquidated damages that amount to multiples of its gross revenue if the breach only affected a specific portion of its operations.

The courts typically require that the parties involved make the most reasonable assessment possible for the liquidated damages clause at the time the contract is signed. This can provide a sense of understanding and reassurance of what is at stake if that aspect of the contract is breached. A liquidated damages clause can also give the parties involved a basis to negotiate from for an out-of-court settlement.

The concept of liquidated damages is framed around compensation related to some harm and injury to the party, rather than a fine imposed on the defendant.

How Do Liquidated Damages Differ From a Penalty Clause?

Liquidated damages are intended to recover what has been lost and make the damaged party whole. A penalty clause, in contrast, is intended to be a form of punishment (punitive).

What Are Unliquidated Damages?

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

What Are the Types of Damages in the Legal Context?

When there is a legal violation that harms or injures another party, there are three general types of compensatory damages (paid out as money) that the plaintiff can seek and which may be awarded by a court:

  • Economic damages to recover money or other financial losses
  • Non-economic damages to make whole for non-monetary losses such as bodily or emotional harm
  • Punitive damages to impose an additional punishment on the guilty party
Take the Next Step to Invest
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Service
Name
Description