In contract law, the parties to a contract may agree upon an amount of "liquidated damages" one party must pay the other if it fails to uphold a certain obligation under the contract. Liquidated damages are intended to protect parties against the damage that could occur if certain obligations aren't met on time.
According to Cornell University's Legal Information Institute, liquidated damages are damages, usually paid in cash, for the breach of a specific contract provision. For instance, if a supplier agrees to deliver machine parts to a buyer by April 15, but does not deliver them until April 16, the supplier may be liable for liquidated damages if the April 15 deadline was a vital part of the contract.
As Cornell University's Legal Information Institute also notes, liquidated damages clauses are frequently included in contracts. They offer a way for parties to "insure" themselves against a particular breach. For instance, a machine parts buyer may insist on a liquidated damages clause that states the supplier will pay a certain amount of money if the supplier fails to deliver the machine parts by a certain date. The money is intended to compensate the buyer for lost sales and other losses that will occur if the buyer doesn't have the parts in time.
Liquidated damages are a special type of actual damages, according to Free Legal Encyclopedia. That is, they are damages paid for a breach that actually occurred. They are not intended to be punitive damages, or damages that punish the breaching party.
Courts will generally uphold reasonable liquidated damages clauses, but will not usually uphold clauses that appear to impose punitive damages. For instance, a court might uphold a liquidated damages clause that says the machine parts supplier must pay for the amount of the sales the buyer would likely lose by not having the parts in time.
The court might not, however, uphold a clause that says the supplier must pay five times the amount of the lost sales. This is because the amount of the lost sales is damage that actually occurred to the buyer, but five times that amount overcompensates the buyer and punishes the seller, instead of merely making things the way they would have been without a breach.
According to Cornell University's Legal Information Institute, in addition to covering actual damages, a liquidated damages clause must also cover damages that could not be ascertained at the time of breach. If the amount of damages is ascertainable, a liquidated damages clause will be struck down in favour of a judgment that the breaching party should pay the actual, ascertained damages amount.
For example, if the machine parts supplier fails to give the buyer the parts in time, and the buyer knows he lost exactly £65,000 in sales by not having the parts, the court will likely require the supplier to pay the £65,000 instead of the amount listed in the liquidated damages clause. However, if the buyer cannot know exactly how much in sales he'll lose, but knows he usually makes about £65,000 in sales, the court will uphold the liquidated damages clause as long as the clause requires damages of in the £65,000 range.
According to the Free Legal Encyclopedia, liquidated damages clauses in contracts offer several advantages. First, they provide a firm number so that both parties can figure the cost of a possible breach into their arrangement. Second, they provide a kind of "insurance" against possible breach. Third, they allow the parties to agree on damages without having to go to court, which saves the parties time and court costs.
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