Liquidated Damages - Valid or Invalid?
In a previous article, I introduced the topic of liquidated damages. As a Delaware business attorney who prepares contracts, I always ask my client to think about how he would be harmed economically if the other party were to breach the contract. With that in mind, we then talk about how easy or difficult it might be to prove the amount of the loss in the event of a breach. Depending on the nature of the business arrangement, there are times when it would be difficult if not impossible to prove the monetary loss that my client will suffer if the other party breaches the contract.
It’s for this reason that we insert a liquidated damages clause in the contract. Let’s not get hung up on terminology. The term “liquidated damages” means that the amount of the dollar loss is known. For example, if XYZ Company promises to pay $50,000 for a shipment, and fails to do so, the amount owed is known. You don’t have to provide evidence that will enable the court to calculate the loss. It’s $50,000. On the other hand, the term “unliquidated damages” means that the amount of the loss is not known. For example, if you purchase an existing business and the contract has a provision prohibiting the seller from competing with you, the amount of your loss could be extremely difficult to prove if the seller opens up a competing business. Think about how you might prove in court under strict rules of evidence the amount of money you will lose because the seller is competing with you.
This is where the concept of liquidated damages comes in. It involves agreeing upon an amount, at the time you enter into the contract, that the other party must pay you if he breaches the contract. It turns what are unliquidated (unknown) damages into liquidated (known) damages.
You cannot use the concept of liquidated damages as a penalty to be imposed on a party for breaching a contract. Instead, the amount has to be a good faith estimate of the damages that would actually be sustained. If the Court determines that the amount in the contract is intended as a punishment for defaulting, it’s considered a penalty and will not be enforced. If that occurs, you could be faced with the difficult if not impossible task of proving the actual damages you sustained.
The Courts in Delaware have established the following test to determine whether the amount inserted in the contract is a penalty or liquidated damages. To be a valid liquidated damages clause, at the time you enter into the contract the amount of damages you might reasonably expect to suffer must be difficult to ascertain because of their indefiniteness or uncertainty. In addition, the amount both parties stipulate to has to be a reasonable estimate of the damages which would probably be caused by the breach.
The good news is that if you have a liquidated damages clause in your contract, and the other party defaults, it’s the defaulting party who has to prove that the amount agreed upon is void as a penalty.
