Liquidated damages Explained
When we negotiate contracts as in-house lawyers for our clients, one of the most confusing terms for business people to understand is the concept of liquidated damages.
This very legal-y concept can be critical for companies and can either represent an important safeguard, or a high risk and unfair penalty.
Liquidated damages are a common provision in commercial contracts, designed to compensate one party when the other fails to meet specific contractual obligations - usually relating to time, performance, or delivery. At their simplest, they provide a predetermined amount of compensation agreed upon at the outset, helping parties avoid uncertainty and dispute further down the line.
The Concept Explained
Rather than calculating actual losses after a breach occurs, a contract may include a liquidated damages clause that specifies a fixed sum payable in the event of non-performance. This sum is intended to reflect a genuine pre-estimate of loss that could reasonably result from the breach.
For example, a supplier agreement might state:
“Liquidated damages of £500 per day shall be payable for each day delivery is delayed beyond the agreed date.”
Why Use Liquidated Damages?
Liquidated damages clauses are used to:
Create certainty: Both parties know in advance what the financial consequence of a breach will be.
Avoid disputes: There's no need to prove or quantify actual loss, which can be complex and contentious.
Manage risk: Liquidated damages allocate the risk of delay or non-performance to the party best positioned to control it.
Incentivise compliance: Knowing that a breach will lead to immediate financial consequences encourages timely and proper performance.
Are They Enforceable?
Generally, liquidated damages are enforceable provided they are not punitive, that is, provided that they’re not a penalty. Courts assess whether the clause represents a genuine attempt to estimate potential loss, rather than a penalty to deter or punish for breach.
To be valid, liquidated damages must:
Reflect a genuine pre-estimate of loss at the time the contract is made - not a speculative or excessive figure.
Be proportionate to the anticipated harm from the breach.
If a clause is found to be extravagant or unconscionable, it may be struck out as a penalty clause, making it unenforceable.
Liquidated vs General Damages
If a contract does not contain a liquidated damages clause, the non-breaching party may still claim general (or unliquidated) damages - but before they get paid, they must prove the actual loss suffered. This often requires evidence, expert reports, and may involve significant legal expense. Liquidated damages, by contrast, can offer a much simpler route to recovery.
However, it can be very difficult to agree what a genuine pre-estimate of loss is, and parties often get stuck in negotiations when liquidated damages are on the table.
Best Practice Tips
When including a liquidated damages clause in your contract:
Be realistic: Choose a figure that fairly reflects potential loss - not a figure designed to punish.
Document your reasoning: Keep internal notes or calculations that show how you arrived at the figure.
Use caps if needed: You can limit exposure by capping liquidated damages at a percentage of the contract value.
Tailor to the contract: Avoid generic clauses - liquidated damages should reflect the specific risks and commercial realities of the agreement.
Final Thoughts
Liquidated damages can be a valuable tool in commercial contracting. They promote clarity, reduce the scope for dispute, and help manage risk effectively.
However, their enforceability depends on careful drafting and a genuine effort to pre-estimate potential loss. And they can be very high-risk for suppliers.
At Hemisphere Consultants, we assist clients in structuring contracts that protect their interests - ensuring that clauses such as liquidated damages are fair, enforceable, and commercially sound.
Need help reviewing or drafting your contracts?
Contact Hemisphere Consultants today for clear, practical advice you can rely on.