FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Liquidated Damages

Updated on March 27, 2024
Article byAndrea Calcagno
Edited byAndrea Calcagno
Reviewed byDheeraj Vaidya, CFA, FRM

Meaning of Liquidated Damages

Liquidated damages refer to a sum of money, which is predetermined in the contract. In case of non-performance of some or all of its obligations, the party in breach is obliged to pay the other party compensation.

A contract will always contain some clauses, maybe a wide range of different clauses. The application of the liquidated damages or LD clause is not specific to a field but a wide variety of areas. It is often triggered by the intent of both parties of the contract to convert the potential damage in quantitative terms. It is quite common in construction and real estate.

Key Takeaways

  • Liquidated damages in a contract refer to the sum of money agreed upon in the signing phase of an agreement that will go to the offended party in case of a breach of said contract.
  • It exists to protect the interest of the party that receives damages, and as such, they tend to be impartial in most cases.
  • In construction and real estate especially, a basic understanding of those clauses is significant since they can be applied in many different manners. So different rulings will be common for different cases if brought to a jury.

How Liquidated Damages Work?

The liquidated damage clause is essential if the numerical value of potential damage associated with the breach of contract is uncertain or complex to determine. Hence, its inclusion will be an advantage to the parties of the agreement because it diminishes the possibility of disagreement between parties to the contract in the future.

Liquidated Damages

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Liquidated Damages (wallstreetmojo.com)

During the preparation of the contract, the parties involved will reach a consensus by liquidating the potential damages due to various activities leading to the non-performance of contractual obligations. If anything happens that is not as per the contract, the affected party can seek indemnification, and the party at fault is liable to pay for damages. However, even if the contract contains the clause with the amount to be paid for damages, it will be legally enforceable only if the amount specified is fair and not grossly disproportionate to the anticipated loss or injury.

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Clauses of Liquidated Damages

LD clause content can be different about diverse scenarios like late payment, non-fulfillment, and early termination. In case of late payment, the clause will be applied if specified on the contract. Such a clause encourages the consumers to pay on time. In non-fulfillment, the clause will be invoked if so specified on the contract. Similarly, users can apply LD clauses to avoid early termination before the expiry of the contract.

Suppose the contract is devoid of the LD clause. In that case, The courts determine unliquidated damages based on evaluating the loss or injury of the party affected by the violation of the contract. The affected party can invoke the clause and receive compensation as long as the contract contains clauses relating to any breach. So there isn’t really a limit to how this particular quibble can be enforced, just more general limitations.

Liquidated Damages in Construction

The construction sector can be subjected to a lot of liquidated damages clauses. For example, it can be applied if the materials used during the building of a property are subpar if the property is not built as specified during the contract if the construction company is late in delivering the product. Also, construction is not specific to the estate building sector. For example, any manufactured goods can be subjected to this clause.

We have a stark example in the case of the Azimut-Benetti yacht company vs. Healey concerning a construction and sale contract in which Azimut Benetti was entitled to receive 20% of the total price as damages in the event of early termination due to buyer default. Although the purchaser had argued that the clause was a penalty clause because the 20% was determined arbitrarily and not on a reasonable basis, the court held that the clause was commercially justifiable and therefore did not qualify as a penalty, so ruled in favor of Azimut-Benetti.

Liquidated Damages in Real Estate

Real estate transactions also make use of liquidated damages clauses. The most common one is for sure the buyer-seller agreement. If the transaction doesn’t go through while buying or selling a property, the party that refused the transaction has to pay an agreed amount in the LD clause based on the property’s value. The inclusion of an LD provision precludes the seller from seeking actual damages.

The legislation in certain states has set a specific rate, and the LD value should not surpass the predefined limit. Therefore, the clause shall be held valid and not a penalty when such amount does not exceed the limit. For example, suppose the limit set by legislation is 5% of the purchase price, and the LD value is 10% of the purchase price. In that case, such provision shall be held invalid, and a penalty unless the party seeking to uphold the provision establishes that such amount is reasonable. To avoid situations like this, ensure this clause is valid, clear, and concise; a real estate lawyer should analyze the documentation of the contract and edit any necessary information to provide for these situations.

Frequently Asked Questions (FAQs)

What is an example of liquidated damages?

Let’s consider the example of LDC in an employment contract mentioning the breach from the employee side. If the employee’s conduct deviates from any of the provisions of the employment agreement, the employee is entitled to pay the LD defined in the LD clause to the employer. The clause also indicates that both parties mutually agree upon the quantitative value determined for the damage.

How is liquidated damages defined?

They are often estimated as a percentage of the contract value. In the case of products or service delivery, the value fluctuates according to the number of days or weeks the products have been delayed.

What is the difference between damages and liquidated damages?

From a contract perspective, the harm accompanying unfortunate events like natural calamities. In contrast, the liquidated damage definition relates more to a contract clause detailing the compensation amount to the aggrieved party in the event of a breach of contract.

This has been a guide to Liquidated Damages & their meaning. We explain how liquidated damages work in construction and real estate and their clauses. You may learn more about financing from the following articles –