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How do liquidated damages work?

On Behalf of | Jun 2, 2022 | Business Litigation

Parties to a contract are expected to comply with its terms. When one party breaches the contract the other party can take legal action. However, contracts also contain remedies when a party breaches its terms which can guide litigation or provide an avenue for parties to resolve their dispute without going to court.

Liquidated damages

Contacts typically contain liquidated damages clauses that address compensation or damages if there is a breach of contract. Well-drafted clauses may also guide courts in determining compensation or losses during business litigation or the parties negotiating a resolution.

A breach of contract occurs when a party to a binding written or oral agreement violates its terms.  Breaches may be minor and involve the failure of a party to complete a contract requirement. A material breach occurs when a party provides a good or service that is different than what was called for in the contract.

Liquidated damages are contained in contracts to cover a hard-to-define or unquantifiable loss to one of the parties. Liquidated damages are usually designed to be fair and reasonable compensation for harm suffered by a party and not as a means to punish the party in breach.

Contract clauses may have liquidated damages to address circumstances where a party faces a loss of assets that are hard to price financially. For example, liquidated damages could apply when a party that discloses vital supply pricing information, or proprietary or trade secret information that does not have a clear market value.

Enforceability

Despite their placement in a contract and the parties’ negotiation of these clauses, fairness and reasonableness govern the extent of these damages that are awarded. Courts usually require that the parties to the contract make reasonable assessments of liquidated damages when the contract is negotiated and signed.

A party seeking compensation or damages for breach of contract should not claim a grossly disproportional amount from the party in breach. Accordingly, courts may not enforce unrealistic liquidated damages clauses.

A court may invalidate, for example, a liquidated damages clause that is greatly disproportional to the actual loss suffered by a party to the contract.  A party cannot claim liquidated damages that involve multiples of its gross revenue if the contract breach involved only a portion of its operations.

Attorneys can help negotiate and draft contract terms that protect business interests. Lawyers may also assist businesses with enforcement and seek compensation and damages in lawsuits.

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