Incentive-ize, Don’t Penalize with Liquidated Damages Clauses for Contract Breaches
Contracts are designed to provide insurance, predictability, and sometimes consequences for a party’s failure to perform its obligations. Those consequences are usually called “damages” and are monetary awards usually for the value of the lost product, service, or other items contracted for. The problem is that the courts are where the scope of damages are fleshed out and these battles are often as dirty and ugly as the battle over whether a party breached in the first place. Without a clause that sets forth the value of damages outright, a contract for services is nearly useless in an era where the value services are increasingly difficult to pin down.
Enter the “liquidated damages” clause. Contrary to what its name suggests, it provides a reasonable pre-determined damages award, adding greater insurance, predictability, clarity, and above all deterrence value to a contract. Such clauses can guard against delay in performance, outright failure to perform, and a variety of other breach scenarios. Moreover, the value of the damages clause does not have to be an accurate portrait of what “actual” damages would be upon breach. They need to be a reasonable approximation of harm suffered, they need to be specific and/or set out a specific formula, and they should not seek to penalize the breaching party.
Take the issue of the early termination of a services contract whereby the non-breaching party would lose revenue from its accounts due to the breach. “Y shall pay X per each of X’s customers, thirty percent (30%) of that customer’s highest monthly usage commission fee during X’s past fiscal quarter multiplied by a factor of six.” This clause provides a specific formula that is patently not a penalty. The goals of the clause are satisfied in that it provides clear relief coupled with deterrence value. Without such a clause, actual damages (i.e. the actual extent of pecuniary harm suffered by the non breaching party would have to be proven), which itself can prove costly in terms time and money.
Drafting Considerations for a Liquidated Damages Clause:
• Any liquidated damages clause should reflect an understanding
of the types of harm one can suffer in a particular scenario, relationship,
and industry. The clause should appear to be a mechanism that attempts
o place the non breaching party in the position that they would be in
had a breach never occurred, though as mentioned, the clause does not
have to be absolutely precise or accurate;
• The ultimate formula or amount should be an approximation of the
actual harm the basis of which can be rationally articulated—in
other words, don’t pick something out of a hat;
• Do not use a clause that is punitive and leads someone to believe
that you are making it impossible to breach without suffering a penalty
above and beyond what the breach costs.
• Some contracts specifically mention that the parties have considered
the provisions and warrant that it does not constitute a penalty. This
language helps but does not automatically insulate the clause from being
deemed a penalty by a court.
To reiterate the above, a special caveat to the businessperson: A liquidated damages clause that appears to be a penalty provision will not get the court’s blessing. Such a clause will not be enforced and the very uncertainty it was designed to guard against will befall the parties. Penalty clauses are inherently disproportional to the scope, nature, and character of the potential harm caused by a breach. Examples include a clause that imposes one million dollars in damages for the failure to deliver a 15 inch television to a family home on time, or a clause that imposes one million dollars for a single day’s delay in delivering that same television.