Importance of Liquidated damages clause in a contract

All commercial agreements begin with the premise that each party to the agreement will honour its respective obligations under the agreement.

However, this is not the case many a times.

If all parties were able to or willing to honour all their obligations, a significant number of lawyers would be out of business.

While providing remedies for non-performance or breach in a commercial contract, a liquidated damages clause can be quite useful. By “Liquidated damages” we mean damages whose amount the parties to a contract quantify and designate during the negotiation of a contract for the non-breaching party to receive as compensation upon a specific breach (e.g., non-performance, late performance or inadequate performance).

Such a clause in a contract helps in reducing ambiguity on the subject matter. The parties can save on a lot of time, money and energy on potential disputes in this regard. A Liquidated damages clause specifies the amount of damages to be paid by the breaching party if it fails to perform specified obligations and otherwise in the event of certain types of breaches under the contract.

The amount agreed as liquidated damages represents the estimate of the parties regarding the likely / anticipated or actual damages suffered by the non-breaching party in the event of a specified breach of the contract by the other (breaching) party.

In most of the cases, the parties agree to liquidated damages in cases where calculation of the actual damages suffered by the non-breaching party is difficult or time consuming. Thus, the contracting parties agree to an amount deemed reasonable and a good estimate of such damages by them.

While upholding claims of a non-breaching party, a court is also likely to go into the reasonability of the amount agreed as liquidated damages.

Typically, a liquidated damages clause includes the following:

• The reason for specification of liquidated damages
• List of breaches exposing the breaching party to liquidated damages
• The amount of liquidated damages (in a specified currency)
• Alternatively, a calculation method to ascertain the liquidated damages (amount slabs, percentages, etc.)
• Confirmation of the parties that they understand and appreciate the reasons and that the amount / formula for liquidated damages is reasonable
• Whether the quantified liquidated damages are the only remedy available to the non-breaching party or are there any other cumulative remedies.

The importance of liquidated damages cannot be undermined as in case of a default, enforcement is not dependent on actual damages suffered by the affected party. The courts too favour the aggrieved party, unless evidence to the contrary (e.g., self-inflicted damage) can be demonstrated.

Happy drafting!