A contract may clarify more than the duties each party must perform. It can also determine what one party must pay if a specified breach occurs.
A liquidated-damages clause sets that amount in advance, giving the parties at issue a measure of financial certainty before problems arise.
What does a liquidated-damages clause cover?
Liquidated damages are intended to compensate a party for losses that may be difficult to calculate after a breach. For example, a construction agreement might require a contractor to pay a fixed amount for every day a project remains unfinished beyond the completion date. The figure represents the anticipated harm caused by the delay.
These provisions may also appear in commercial leases, purchase agreements, service contracts and confidentiality agreements. Depending on the wording, the clause may establish a single payment or an amount that increases with the duration of the breach.
The injured party does not have to prove the precise value of the covered loss when an enforceable clause applies. However, that party must still show that the specified breach occurred.
When is this kind of clause enforceable?
Calling a payment liquidated damages does not automatically make the provision valid. Courts usually examine the clause’s purpose and the circumstances that existed when the parties formed the contract.
An enforceable amount should reflect a reasonable estimate of the loss the parties expected a breach to cause. The actual harm must also have been uncertain or difficult to measure at the time the agreement was made.
A court may refuse to enforce a clause designed to frighten or punish the breaching party. An amount that is greatly disproportionate to the anticipated loss may be treated as an unenforceable penalty.
Before signing a contract, each party should consider whether the amount noted reasonably reflects the likely consequences of nonperformance. An experienced legal team can assess a provision under Maryland’s applicable law. Careful review can help to better ensure that a clause will serve as a basis for providing fair compensation – when appropriate – without functioning as a penalty.