Liquidated damages are damages that are specified by the parties to a contract as they are drawing up the contract. This part of a contract specifies that, in the event one party breaches the contract, he must pay a specified amount to the other party for his losses. In some cases, the specific amount to be paid as liquidated damages is not stated, the amount is considered “at large,” and must be determined by a court. To explore this concept, consider the following liquidated damages definition.
Definition of Liquidated Damages
- A monetary award to compensate a party to a contract, when the other party has breached that contract.
What are Liquidated Damages
Liquidated damages are damages that are included in a contract to compensate for a potential breach of the contract. This means that the party or parties who are injured by such a breach will be compensated for their injury. The exact amount of damages to be awarded is commonly stated in a liquidated damages clause, though that is not required. If the amount is not specified, it is considered “at large,” meaning that a court or other tribunal will determine the appropriate amount to award if and when a breach actually occurs.
Liquidated Damages Clause
A liquidated damages clause lays out the amount of damages that would need to be paid to the injured party if a breach of contract were to occur. An example, liquidated damages might be paid out if one or more parties to the contract failed to perform their duties as expected. The amount determined in a liquidated damages clause is supposed to be a best estimate of the compensation that would be appropriate if the parties to the contract were to suffer a breach. Liquidated damages clauses typically specify certain types of breach, denoting the amount to be paid for each.
The downside to a liquidated damages clause is that it is not always enforceable. If the estimate is ultimately way too high compared to the actual harm the injured party incurred, the court will not enforce the clause. The court’s decision would be based on the fact that the amount is more of a penalty than an amount to make the injured party whole. There are two criteria in particular that a liquidated damages clause must meet in order to be enforceable. In the event there is no liquidated damages clause, or if the amount is determined to be unreasonable, the court may determine the amount of damages to be paid.
Amount is Difficult to Estimate
If, when the contract was initially created, the amount of damages that might be incurred in the event of a certain type of breach was difficult to estimate, the court would probably enforce the liquidated damages clause. For example, liquidated damages that would be difficult to estimate, or to prove, would be those incurred from a breach of confidentiality. A breach that resulted in a loss of profits, however, would be easier to calculate. In order for damages to be enforceable, they must be either undefined or difficult to measure when the contract is entered into.
Reasonableness of the Amount
To enforce the reasonableness of the amount of damages specified in such a clause, courts look to what would have been considered reasonable when the contract was formed, as opposed to when the breach actually took place. If the amount of liquidated damages specified ends up being severely overestimated, compared to the actual harm incurred, then the courts generally find the amount to be more of a punishment than an estimate.
In this case, the courts would not enforce the liquidated damages clause. State laws vary insofar as how liquidated damages clauses in contracts are to be executed, if at all. Some states require that certain terms be incorporated into the clause in order for the provision to be enforceable.
To determine reasonableness, courts may consider the parties’ bargaining power. For instance, courts are more likely to analyze a car rental agreement in depth, rather than a contract between two attorneys, due to the car rental company’s superior bargaining power in the deal. What this means is that a car rental company can exert more influence over a customer than can an attorney with credentials rivaling those of another attorney. Therefore, it is more likely that the customer in this scenario would suffer significant, unfair damages as a result of a breach of contract.
Benefits of a Liquidated Damages Clause
There are certain benefits of a liquidated damages clause that make it invaluable in a contract. For one thing, it establishes some level of predictability, even if it is not precise, and can therefore act as a kind of insurance against a potential breach. Another benefit of a liquidated damages clause is that the parties are able to measure the cost of actually performing their duties against what it would cost them if a breach actually happened.
An additional benefit of a liquidated damages clause is the non-defaulting party will never need to prove actual damages, which can be a complicated and time-consuming process. When done right, addressing the issue of damages from the very beginning of a contract’s formation can give all parties the opportunity to agree on an amount that they feel would be fair, should a breach occur. This is preferable to leaving such a decision up to what can be a very unpredictable, expensive, and time-consuming litigation process.
Liquidated Damages Example Involving a Basketball Coach
An example of liquidated damages can be found in a case wherein a basketball coach breached his contract with his university employer to take an identical position at a higher paygrade. In April of 2008, Gene Ford and Kent State University (KSU) entered into an employment contract that would make Ford the head men’s basketball coach at the school. It was agreed that Ford would work at KSU for four years, with the option of an additional year, for a total of five years. The contract contained a liquidated damages clause which stated:
“Gene A. Ford recognizes that his promise to work for the University for the entire term of this four (4) year contract is of the essence of this contract with the University. Gene A. Ford also recognizes that the University is making a highly valuable investment in his continued employment by entering into this contract and its investment would be lost were he to resign or otherwise terminate his employment with the University prior to the expiration of this Contract. Accordingly, he will pay to the University as liquidated damages an amount equal to his base and supplemental salary, multiplied by the number of years (or portion(s) thereof) remaining on the contract.”
Two years later, Ford and KSU renegotiated the contract. A new agreement was drafted, employing Ford for a five-year term, at a higher salary, which paid him an additional $100,000 on top of the $200,000 he was already earning. In March of 2011, however, Ford left KSU and accepted the same position at another school, Bradley University, and for a whopping increase of $400,000 in his annual salary.
KSU filed a civil lawsuit against Ford for breaching his contract. There were three issues here that needed to be decided in order to determine whether the liquidated damages clause in Ford’s contract was enforceable.
- The court had to decide whether the clause was unenforceable, if it required that Ford, now a breaching party, continue to be paid his salary as agreed for each year remaining under the contract.
- The court had to decide whether the clause was unenforceable because of the limited evidence available that proved actual damages.
- The court had to decide whether damages in such a case should only include the salary of a replacement coach – in other words, what it would cost KSU to hire someone to replace Ford.
Ford argued that the liquidated damages clause was nothing more than a deterrent meant to stop him from accepting employment elsewhere. Ultimately, the trial court granted summary judgment in KSU’s favor. Ford then appealed to the Eleventh Appellate District in Portage County, Ohio, however the Court of Appeals ultimately affirmed the lower court’s decision, saying:
“As discussed extensively above, there was justification for seeking liquidated damages to compensate for Kent State’s losses, and, thus, there was a valid compensatory purpose for including the clause. While there was some testimony the clause would deter Ford from leaving, this would be true of liquidated damages clauses in almost every contract, since an award of damages deters a breach. It appears that at least some losses were contemplated prior to the inclusion of this provision in the contract. Given all of the circumstances and facts in this case, and the consideration of the factors above, we cannot find that the liquidated damages clause was a penalty.”
Related Legal Terms and Issues
- Actual Damages – Money awarded to compensate someone for actual monetary or property losses. Also referred to as “compensatory damages,” the amount of money awarded is based on the proven loss, injury, or harm proven by the plaintiff.
- Contract – An agreement between two or more parties in which a promise is made to do or provide something in return for a valuable benefit.
- Damages – A monetary award in compensation for a financial loss, loss of or damage to personal or real property, or an injury.
- Summary Judgment – A final decision on the case, handed down by the judge on the basis of the statements and evidence presented, without a full trial.