What are liquidated damages?
UPDATED: December 15, 2019
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Liquidated damages are damages that the parties to a contract specify will have to be paid in the event of a breach. For example, if Ann and John make a contract to do business, one provision of that contract may stipulate that if either of the two breaches the contract and doesn't fulfill the promise, that person will have to pay the other $1,000. The clause setting this $1,000 payment penalty is a liquidated damage clause, with the $1,000 being the "liquidated" damages that will have to be paid. Liquidated damages provisions are not used in every contract, but they may make sense in certain instances.
Using Liquidated Damages
When most breach of contracts cases occur, the damages that are awarded are based on the actual financial loss incurred by the party who suffered the breach. Sometimes, this is easy to figure out. For example, if Joe is renting an apartment from Ann for $500 a month and then Joe breaks the lease and Ann can't find a new tenant for a month, then Ann has suffered $500 in damages and that would be what Joe has to pay.
Sometimes, however, it can be difficult or impossible to calculate how much a breached contract would cost. As such, the parties to the contract can decide on an amount that will need to be paid if either breaches and they can include details about that amount right in the contract. The court will generally enforce the liquidated damages provision and make the breaching party pay whatever is specified, if it finds that a breach did, in fact, occur. However, courts will usually only enforce a liquidated damages clause if the damages really are difficult to determine and if the clause is reasonable (i.e. not punitive—you can't put a clause in a contract specifying $1 million in liquidated damages if you really only lose about $100).
If you are writing a contract with a liquidated damages provision, or considering signing one, getting a lawyer involved is a good idea to help make sure your legal rights are protected.