Preparing for a Liquidated Damages Dispute: Tactics for Increasing Your Odds of Success

Liquidated damages—a pre-set sum of money that you agree on in a contract as the amount one side will receive if the other side breaches—are common in commercial contracts. Unfortunately, disputes over enforcing liquidated damages are almost as common. If you are trying to recover liquidated damages or avoid paying them, here are some tips that will help increase your odds of success.

To be enforceable, a liquidated damages clause must generally satisfy five critical elements (although this varies from state to state and from country to country):

• Actual damages must be difficult to quantify
• The amount must be liquidated (i.e., agreed upon and set in advance)
• The amount must be reasonable
• The damages must be compensation, not a penalty
• The damages must be exclusive (i.e., the only remedy available)

Difficult to Quantify

Damages, like the weather, are challenging to predict. Therefore, this element doesn't often arouse disputes. A liquidated damages clause in which each party affirms that future damages will be difficult to quantify usually satisfies this requirement.

Liquidated

The amount of damages must actually be liquidated. In other words, the contract must identify the amount one party will receive, or must pay, if a breach occurs. Usually this is done by stipulating a specific dollar amount or a formula (e.g., a set amount for each day a breach continues). The simpler the formula, the better. Here's a good rule of thumb: if you need more than the contract, a calculator and a calendar to determine the amount, the liquidated damages will probably be difficult to enforce.

Reasonable

Whether the amount of liquidated damages is reasonable is a central feature in most disputes. Although it is impossible to identify what will be considered reasonable in each case, these guiding principles can help:

• Best Estimate: Set the amount using the best estimate available. Ask yourself these questions: If the other party doesn't do what they promised, what kinds of damages am I going to suffer? What out-of-pocket costs will I have to pay? To whom will I not be able to keep my promises and what will be the resulting fallout? What is the value of any opportunities I'll lose? The more analysis like this that goes into underwriting the liquidated amount, the better the odds a judge will (a) find the amount reasonable and (b) not consider it an enforceable penalty (more on penalties below).
   
• Prepare to Defend the Estimate: If you have to enforce the liquidated damages, odds are you'll face a hostile lawyer and a skeptical judge. You'll be in a stronger position if you are well-prepared to answer questions about how you set the liquidated amount in the first place. Answers revealing a process of intense and comprehensive analysis will enhance the odds that the amount will be found reasonable and enforceable; answers revealing a causal, or improvised, approach will erode those odds.

Not a Penalty

For more than 150 years, Anglo-American contract jurisprudence has required that damages for breach of a contract focus on compensating the party that did not breach the contract, rather than punishing the party that did. Therefore, if the liquidated amount is really a penalty imposed on the breaching party, or a coercive device for deterring a potential breach, a judge won't enforce the liquidated damages.

What's the best way to avoid this scenario? For starters, set the amount based on your best estimate as explained above. Furthermore, don't refer to liquidated damages as "penalties."

Exclusive

Usually, to be enforceable, liquidated damages must be the exclusive remedy for breach of the applicable promise in the contract. In other words, you get liquidated damages, and only liquidated damages. If the contract provides an alternate means of measuring damages, chances are the liquidated damages clause will be unenforceable.

The Final Analysis

Although there are never guarantees, you can significantly increase your odds of reaping the benefits of liquidated damages in your contracts. One of the best ways is to ensure that you satisfy each of the elements outlined above, especially (a) setting the amount of damages at your best forecast of damages you could suffer and (b) agreeing to that amount as your only remedy if a breach of select contract terms occurs. On the other hand, if you are opposing liquidated damages, focusing on these areas may yield better odds of successfully avoiding enforcement of liquidated damages against you.