Liquidated Damages Provisions in Commercial Contracts: Money in Your Pocket or Money Left on the Table?
Every commercial contract, regardless of industry or subject matter, involves two fundamental elements: opportunity and risk. Opportunity is the reason the parties entered into the agreement in the first place. Risk, on the other hand, is often the focus of extensive negotiation and drafting as each party seeks to limit its exposure and minimize the damages or losses it could face if the deal or business relationship goes sideways.
And deals often go sideways.
Misunderstandings arise. Deadlines are missed. Deliverables fall short. When that happens, the injured party may pursue a claim against its contractual counterpart to recover the losses resulting from the breach or other wrongful act or omission. But calculating actual damages and putting a dollar value on those losses can be difficult, expensive, time-consuming, and uncertain.
That is why many commercial agreements include a liquidated damages provision. Rather than requiring the non-breaching party to prove its actual losses, these clauses establish in advance an agreed-upon amount or formula for calculating damages regardless of, and in place of, the party’s actual damages. But is that always a favorable arrangement for the injured party? Does eliminating the burden of proving damages come at the cost of accepting compensation that falls well below the losses actually sustained?
If you are considering entering into a commercial contract containing a proposed liquidated damages provision, here are some of the advantages and disadvantages of this common contractual term.
What Are Liquidated Damages Provisions?
In any lawsuit, including one involving a commercial contract, the plaintiff generally must prove two essential elements: liability and damages. A liquidated damages provision effectively establishes the second element in advance, functioning much like a pre-negotiated settlement amount. These clauses commonly appear in construction contracts (assessing damages for delayed project completion), software agreements (service level agreement credits), real estate transactions (forfeited earnest money deposits), and employment agreements (violations of non-compete provisions), among many other types of contracts.
The Advantages of Liquidated Damages
The case for including a liquidated damages provision has several components, each of which can be appealing, at least in the abstract.
Certainty
Business owners value certainty and predictability just as much as they seek to avoid unnecessary risk. A liquidated damages provision can provide both. If a contractor knows that missing a project milestone by one week will result in $5,000 in damages rather than an unknown amount determined by a jury years later, the contractor can make informed business decisions and price its contracts accordingly.
Lower Litigation Costs
When a party’s attorneys need only establish liability and are not required to spend significant time and resources proving the amount of damages through expert testimony, financial analysis, document discovery, and related disputes, litigation costs can be substantially reduced. If the breach is clear, the remedy is clear. That alone can save both parties tens of thousands of dollars in legal fees.
Compensation When Actual Damages Are Difficult To Measure
Some losses resulting from a breach of contract are very real but inherently difficult to quantify. Lost profits resulting from a supplier’s delayed delivery, reputational harm caused by a failed product launch, or the cascading effects of a construction delay are all legitimate injuries that may not lend themselves to precise calculation. A properly drafted liquidated damages provision can provide compensation even when actual damages would be difficult or impossible to prove with certainty.
The Risks and Downsides of Liquidated Damages
Despite their benefits, liquidated damages provisions are not without potential drawbacks that can either limit their value or render them worthless.
Liquidated Damages Are Not Automatically Enforceable
Although courts frequently enforce properly drafted liquidated damages provisions, enforcement is never guaranteed. In Michigan, the governing standard is found in MCL 440.2718. While the statute permits parties to liquidate damages by agreement, the amount must be “reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy.”
Just as importantly, the statute makes clear that if the agreed-upon amount is excessive, the clause will fail entirely: “A term fixing unreasonably large liquidated damages is void as a penalty.”
Accordingly, if a court concludes that a liquidated damages provision is punitive rather than compensatory, it will refuse to enforce it. Careful drafting is therefore essential for parties that intend to rely on such a provision and make business decisions based upon its anticipated application.
Leaving Money on the Table
While an enforceable liquidated damages clause guarantees compensation in the event of a breach, that compensation may fall well short of the non-breaching party’s actual losses. Businesses should carefully consider whether the certainty provided by the provision is worth accepting a potentially low and inadequate ceiling on their recovery.
Not Changing With the Times
Long-term contracts present another challenge. A liquidated damages amount that was reasonable when the agreement was executed may become inadequate years later due to inflation, changing market conditions, or an expanded scope of work. For that reason, parties should periodically review long-term agreements and consider including provisions that permit adjustments to liquidated damages under defined circumstances.
Liquidated damages provisions are a legitimate and often excellent risk management tool, but they require careful consideration to ensure the potential upsides outweigh the downsides, and they must be carefully drafted to be enforceable. If you have any questions about liquidated damages in your company’s contracts, please contact Michael Hamblin at Maddin Hauser.