Part of the fun in contract drafting is that the parties can put everything, including the kitchen sink, into the agreement, including what happens when one party breaches the contract. The idea of liquidated damages, money paid to the non-breaching party, was one of the most head-scratching concepts my first-year study group grappled with in law school, but as a practitioner, adding this provision to a contract can be a huge time saver for all parties involved.
These types of damages can appear in all forms of contracts. In a confidential settlement agreement, agreeing to a certain amount of liquidated damages can provide additional “incentive” to keep the parties from speaking publicly about the terms of the agreement. In shipment contracts, liquidated damages may increase each day a carrier delays delivery of a package. They act as insurance, so that the receiver is compensated for the delay, and so the shipper can more adequately weigh the cost of such a delay.
In practice, they can provide a jumping off point for settlement negotiations after a contract is breached. If the parties agree on liquidated damages of US $300,000 in the event of a breach, the parties may eventually negotiate a lower settlement, but the number of zeros in question is less likely to be part of the debate.
One major question to address is whether the court would allow a claim for liquidated damages to move forward in the first place. Although Jurisdictions from China1 to New York2 allow parties to seek liquidated damages as anticipation of a breach, it is very important to remember that courts in many jurisdictions will not uphold that part of a contract if that provision is punitive rather than compensatory.
However, before writing these damages into your contract you should be aware of potential limitations on these seemingly agreed-upon damages, especially when the parties are from different jurisdictions and different countries, you should keep in mind that different courts treat liquidated damages provisions differently – one of the reasons why it is important to invest in a qualified lawyer at the outset of the contract negotiation and drafting stage, rather than one to step in after the relationship has deteriorated. First, you may save the relationship with the other company, and second you may save a significant amount of money in legal fees.
Note: this article is not intended to provide legal advice. If you want to speak with an attorney specializing in contract negotiation and drafting, please contact Anderson & Anderson LLP at firstname.lastname@example.org.
1. The People's Republic of China Contract Law Article 114 The parties may stipulate that in case of breach of contract by either party a certain amount of penalty shall be paid to the other party according to the seriousness of the breach, and may also stipulate the method for calculating the sum of compensation for losses caused by the breach of contract.
If the stipulated penalty for breach of contract is lower than the loss caused by the breach, the party concerned may apply to a people's court or an arbitration institution for an increase. If the stipulated penalty for breach of contract is excessively higher than the loss caused by the breach, the party concerned may apply to a people's court or an arbitration institution for an appropriate reduction.
If the parties agree upon a penalty for the breach of contract by a delayed fulfillment, the breaching party shall, after paying the penalty for breach of contract, discharge the debts notwithstanding.
2. “liquidated damages [are]. . . an estimate, made by the parties at the time they enter into their agreement, of the extent of the injury that would be sustained as a result of breach of the agreement… A contractual provision fixing damages in the event of breach will be sustained if the amount liquidated bears a reasonable proportion to the probable loss and the amount of actual loss is incapable or difficult of precise estimation. If, however, the amount fixed is plainly or grossly disproportionate to the probable loss, the provision calls for a penalty and will not be enforced." [citations omitted] JMD Holding Corp. v. Congress Financial Corp., 4 N.Y.3d 373, 380 (N.Y. Mar. 31, 2005)