What Are Liquidated Damages (LDs)? How They Work, With Example

Will Kenton is an expert on the economy and investing laws and regulations. He previously held senior editorial roles at Investopedia and Kapitall Wire and holds a MA in Economics from The New School for Social Research and Doctor of Philosophy in English literature from NYU.

Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital.

What Are Liquidated Damages?

Liquidated damages (LDs) are a sum of money specified in some contracts that are to be paid by one party to another as compensation for intangible losses. Liquidated damages are to be paid only if one of the parties to the contract is found to be in breach of contract.

The liquidated damages clause covers events such as a missed deadline or a leaked company secret. The damage is real but a precise dollar loss is difficult to pin down. Instead, both parties to the contract settle on a number that reflects the importance of meeting the terms of the contract.

Key Takeaways

• Liquidated damages (LDs) are an estimate of intangible or hard-to-define losses to one of the parties in a contract.
• These damages are to be paid out in the case of a breach of contract; they are estimated and spelled out in advance in the contract.
• Liquidated damages are meant as a fair representation of losses in situations where actual damages are difficult to ascertain.
• The courts typically require that the parties involved make the most reasonable assessment possible for the liquidated damages clause at the time the contract is signed.

Understanding Liquidated Damages

Liquidated damages are meant as a fair representation of losses in situations where actual damages are difficult to ascertain. In general, liquidated damages are designed to be fair, rather than punitive.

Liquidated damages may be referred to in a specific contract clause to cover circumstances where a party faces a loss from assets that do not have a direct monetary correlation. For instance, if a party in a contract were to leak supply chain pricing information that is vital to a business, this could fall under liquidated damages.

Example of Liquidated Damages

Liquidated damages provide compensation for losses that are difficult to measure with any degree of accuracy. For example, an agreement to purchase a home might include a clause that requires the buyer to forfeit the deposit if the deal fails to go through. Alternatively, a contract between two companies might include liquidation damages if trade secrets or other confidential company information is improperly shared.

One common example of a liquidated damages clause appears in contracts between a company and its outside suppliers and consultants for a new product. The product design and the marketing plan don't have a set market value, but the company's bottom line could suffer if they are leaked to a competitor. The liquidated damages clause allows the company to collect some compensation.

Special Considerations

The courts do not always enforce liquidated damages clauses. It may reject the clause if the monetary amount cited is extraordinarily disproportional to the real effects of the breach of contract.

Such limitations prevent a plaintiff from attempting to claim an exorbitant amount from a defendant. For instance, a plaintiff might not be able to claim liquidated damages that amount to multiples of its gross revenue if the breach affected only a portion of its operations.

The courts typically require that the parties involved make the most reasonable assessment possible for the liquidated damages clause at the time the contract is signed. This provides a shared understanding of what is at stake if that aspect of the contract is breached. A liquidated damages clause can also give the parties involved a basis to negotiate for an out-of-court settlement.

The concept of liquidated damages is framed around compensation for some harm and injury to the party, rather than a fine imposed on the defendant.

How Do Liquidated Damages Differ From a Penalty Clause?

A liquidated damages clause is designed to allow a party to a contract to recover a loss. A penalty clause is punitive. It is intended as punishment.

What Are Unliquidated Damages?

Unliquidated damages are similar to liquidated damages. Both seek to compensate a harmed party for a breach of contract. The amount of unliquidated damages, however, is not specified in the contract, as is the case for liquidated damages.

What Are the Types of Damages in the Legal Context?

There are three general types of compensatory damages that the plaintiff can seek and which may be awarded by a court:

• Economic damages to recover money or other financial losses
• Non-economic damages to make a party whole for non-monetary losses such as bodily or emotional harm
• Punitive damages to impose an additional punishment on the guilty party

The Bottom Line

A liquidated damages clause is fairly common in contracts when one party has concerns about the possibility of losses caused by errors or misjudgments by the other party. These losses are by their nature difficult to estimate. They may be related to loss of potential sales, loss of reputation, or loss of competitive edge.

In any case, the number attached to a liquidated damages clause creates a shared understanding between the parties to a contract of the value of meeting the contract terms.