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Liquidated Damages: Damages Due to Breach of Contract

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  • 0:05 Liquidated Damages
  • 2:44 Liquidated Damages Clause
  • 5:00 Advantages of…
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Lesson Transcript
Instructor: Ashley Dugger

Ashley is an attorney. She has taught and written various introductory law courses.

When a breach of contract occurs, there are several different types of money damages that might be awarded to the innocent party. Liquidated damages are a predetermined form of money damage award. This lesson explains the use of liquidated damages.

Liquidated Damages

I got a new job! Unfortunately, it's in another state and I start next week. So, I make you a sweet deal on my house, and you agree to buy it from me. We make a contract that says you'll pay $100,000, and we'll close this deal at the end of the month. You make a down payment of $10,000. Our contract says that I can keep your $10,000 if you don't end up closing the deal and buying my house. However, if I prevent the purchase, then you get your $10,000 back.

Wait a minute! You're not so sure about this. Is this term intended to punish you? Is this term even enforceable? Should you sign the contract as it is, or should you object to this term?

When a party breaches a contract, money damages are usually awarded to the innocent party. But, there are actually several different types of money damage awards. There's even a type that can be decided when the contract is made and before the contract is ever breached. Liquidated damages are a predetermined form of money award. This means that the parties already agreed on the amount of money that would be awarded should one of the parties breach the contract. Liquidated damages are an amount estimated to equal, or best approximate, the amount of loss an innocent party will incur if the contract is breached.

For example, if you breach the contract then I'll have to put my house back on the market. I'll incur expenses in this process. I may have more mortgage payments due while I try to sell my house. There will also be costs to clean and maintain my house while I'm showing it, like mowing my yard or shoveling snow from the sidewalk. Rather than calculating these expenses exactly and suing you for those damages later, our liquidated damages clause is an attempt to approximate my anticipated loss now.

This determination is set out as a term of the contract and included in the contract when the parties execute the contract. That contract term is called a liquidated damages clause. In our contract, we have a liquidated damages clause for $10,000. It's helpful to note that 10% is a fairly standard and typically enforceable formula for liquidated damages in a real estate contract. Our liquidated damages clause is for the standard 10% of the entire contract amount.

Liquidated Damages Clause

A liquidated damages clause isn't a good fit for all contracts. These clauses are most often included in contracts that involve the exchange of money, an agreement to perform a particular act, or the sale of real estate. Our contract is a real estate contract, since it involves the sale of my house. All liquidated damages clauses must meet certain requirements. A court won't enforce a liquidated damages clause unless:

  1. The loss to the innocent party will be either too uncertain or too difficult to calculate.
  2. The specified damages amount is reasonable, considering the innocent party's actual and anticipated loss, the party's difficulty of proving the exact amount of the loss, and the court's difficulty of applying another, adequate remedy.
  3. The damages are intended to function as compensation to the innocent party, rather than as a penalty to the breaching party.

If the liquidated damages clause sets a damages amount that is disproportionate to the innocent party's anticipated actual loss, then the court will consider the clause to be a penalty and won't enforce the clause. The court will pick another, more appropriate remedy. Liquidated damages aren't intended to serve as a punishment or as a deterrent against a breach of contract.

Let's take another look at our contract. Let's say that we estimate the costs for cleaning and maintaining my house while it's potentially back on the market and add a few months worth of mortgage payments. This amount is $5,000. Since this is only half the amount of our liquidated damages clause, our clause likely won't be enforced. Instead, under this particular scenario, the court will pick a more appropriate money damages award. Keep in mind that a court will never enforce a liquidated damages clause that isn't part of a valid, legal contract. If the contract is unenforceable for any reason, the clause will fail. Our contract appears to be a valid, legal contract that is typical of other real estate contracts.

Advantages of Liquidated Damages

Though common in real estate contracts, the use of liquidated damages is actually fairly limited. However, these clauses provide several different advantages when they are used. First, this type of damage clause allows the parties to accurately predict the costs involved in breaching the contract. That way, the parties can weigh the cost of performing the contract against the cost of breaching the contract. Parties can make an informed decision when considering a breach or even when considering whether or not to enter the contract.

Second, this type of damage clause allows the parties to negotiate damages while drafting the contract. Since the amount is mutually agreeable, the parties will hopefully avoid the time, effort, and fees involved in arguing a breach of contract court case. Third, this type of damage clause allows the parties to have a certain amount of protection and assurance. Liquidated damages guarantee that the parties won't exit the contract empty-handed. Once the parties execute the contract, they know that they'll either receive the agreed-upon performance, or they'll receive the agreed-upon damages.

Let's take another look at our contract and at some of the benefits this clause provides. For you, the buyer, the liquidated damages clause can serve to limit your damages if you breach the contract. Let's say that you don't buy my house, and it ends up taking me almost a year to sell it. That's thousands of dollars in extra mortgage payments.

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