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A guide to 'Liquidated Damages' clauses

Many business contracts are not fulfilled as per the terms contained. Sometimes, any one party can breach the contract, thereby causing a loss to the other party. The purpose behind these clauses is not to punish the person who breaches the contract. Below is a guide to 'Liquidated Damages' clauses.

About liquidated damages clauses

Liquidated damages are damage clauses in a contract that provide for compensation to be paid in case the contract is breached. The amount that is agreed upon as damages must be a reasonable estimate. It must not be a penalty. Where are they found? Liquidated damages clauses are typically found in contracts where a specified amount is difficult to fix because of fluctuating circumstances. For example, a real estate contract contains liquidated damages clauses that specify a fixed sum of money to be paid if any one of the parties does not follow the terms of the contract. Such clauses are omnipresent in real estate and employer-employee contracts. Advantages 1. They ensure that no party can treat the contract lightly and wilfully step outside its terms, thereby causing unfair damage to the other party. 2. Both parties know how much financial damage they will suffer if they breach the contract. In that way, they can calculate their financial losses beforehand. 3. In case terms are breached, both parties can negotiate around the fixed amount and resolve the case without approaching the court. Enforcing liquidated damages clauses 1. Liquidated damages clauses cannot be enforceable if their intention is to punish the wrongdoing party. The intention must be to justly and fairly compensate the party who suffers a loss. 2. If the liquidated damages clauses read like “punishing” clauses, then they are treated as penalty clauses. A penalty is a sum that is not related to the actual loss that can be caused – penalties are arbitrary sums that seek to punish people who breach contracts. Liquidated damages are “estimation” of damages. 3. The clauses must not seek to unfairly enrich the party that enforces them.

Two conditions must be fulfilled in order for enforcing liquidated damages clauses:

1. The amount of liquidated damages that is fixed must be a close and reasonable approximation of the damage that will be caused on breach of contract. 2. The amount of damages must be uncertain at the time when the contract is entered into, and it should be clear that having such clauses quantifying them will help both parties from facing hurdles in estimating the damages in the future (if and when they occur). Note: When it is mathematically impossible to quantify the damages at the time when the contract is made, such damages are referred to as unliquidated damages.

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