Liquidated damages - effective and enforceable?

When a contract goes wrong, proving actual losses can be expensive, time-consuming, and uncertain. Liquidated damages clauses solve this problem by agreeing upfront what compensation will be paid if specific breaches occur.

The dilemma with liquidated damages is balancing certainty with enforceability. For a liquidated damages clause to be enforceable, it must be a genuine pre-estimate of likely loss, not a penalty. Courts may strike down penalty clauses as unenforceable. The test is - was the sum a reasonable forecast of probable loss when the contract was made?

Contracts which often include liquidated damages clauses

• Construction contracts -  damages typically calculated as a daily or weekly rate for delays in completion

• Confidentiality agreements and NDA's - liquidated damages clauses can be especially problematic in confidentiality agreements. This is because it's often very hard to estimate the financial loss caused by a breach, like reputational harm or loss of competitive advantage. If the liquidated sum is too high and not a genuine estimate of likely loss, courts may treat it as a penalty and refuse to enforce it.

• Software agreements - often include liquidated damages for delays in system delivery or failures to meet performance metrics

• Commercial leases - may include liquidated damages for late vacation of premises or early termination

• Service level agreements - often incorporate liquidated damages in the form of service credits for performance failures

• Supply contracts - may include liquidated damages for late or incomplete deliveries

• Distribution agreements - can include liquidated damages for failures to meet minimum purchase requirements

• Outsourcing contracts- typically include complex liquidated damages regimes for service failures

• Share purchase agreements - for breaches of warranties or covenants

Risks

1. Enforceability risk - if poorly drafted, the clause may be deemed a penalty and rendered unenforceable, leaving the innocent party to prove actual damages

2. Limitation risk - a liquidated damages clause may act as a cap on recoverable damages, potentially limiting recovery if actual damages exceed the pre-agreed sum

3. Under-compensation risk - if the pre-estimated damages are lower than actual damages, the innocent party cannot claim the difference

4. Amendment risk - failure to review and update liquidated damages provisions when contract values change can render them unenforceable

5. Uncertainty related risk  - ambiguous drafting can create uncertainty about when and how the clause applies, potentially leading to disputes

How we can help

• Our commercial contracts team have has extensive experience drafting and reviewing liquidated damages provisions across various industry sectors.  We provide strategic advice on negotiation positions and fallback options. We also assist clients in developing enforceable pre-estimates of loss, This can mean working with construction consultants, accountants or engineers.

• Our dispute resolution and enforcement solicitors can assist with advising on the enforceability of liquidated damages provisions and calculating and proving damages when liquidated damages clauses are or may be unenforceable.