In the context of commercial contracts the term “liquidation” means to fix or establish the damages owed in the event of a breach of contract. Rather than add the calculation of the dollar amount of damages for breach to a list of items in dispute, a carefully drafted liquidated damages (“LD’s”) provision can establish the dollar damages for breach at the outset of the relationship. The law on the enforceability of LD’s varies slightly from state to state but the general rules are well settled and fairly easy to implement. Using a well crafted LD’s provision in a contract can offer benefits to both parties as they allocate particular transaction risks.
For sellers of goods, the Uniform Commercial Code (“UCC”) provides a simple basis for recovery of liquidated damages as a remedy for breach of contract:
UCC § 2-718. Liquidation or Limitation of Damages; Deposits.
(1) Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty.
Note, this section of Article 2 above is not an actual liquidated damages provision but rather it serves as a basis for enforceability in sales contracts. Most states have adopted versions of the UCC Article 2 for application within their jurisdiction. The UCC provision sets forth elements that are typically considered when actual LD provisions are litigated to determine intent and enforceability.
Likewise the Restatement (Second) of Contracts Section 356(1) also provides a basis for LD’s as a remedy in breach of contract cases in the event the UCC does not apply:
§ 356. Liquidated Damages and Penalties
(1) Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.
Both the UCC and the Restatement seek to serve the goal of allowing the parties to stipulate damages for breach at the time of contracting to save the time of the courts and the parties in the event of litigation and thereby reduce the cost of resolving disputes. This is especially true where the damages are small and best resolved by the parties. The parties should be free to negotiate fair compensation for a breach so long as the remedy does not become punitive in nature crossing the line into an unenforceable penalty.
In most instances an LD provision will be upheld if the damages would be:
Uncertain as to amount and difficult to prove;
Not unconscionable and disproportionate in amount as related to reasonable intentions of the parties;
Consistent with conclusion that the parties intended damages in such amount would follow a breach.
The following is a sample provision that may be appropriate for use as a basis for developing a contract specific remedy:
“The parties acknowledge that given the uncertainty they anticipate associated with the ability to calculate the buyer’s damages for the seller’s failure to deliver the goods in accordance with the schedule, the amount stipulated herein as liquidated damages is a good faith estimate of reasonable compensation for the damages resulting from late delivery and that such liquidated damages are not intended, and shall not be construed, as a penalty.”
Note: The sample provision above is for illustration purposes only and is not intended for use without appropriate review in your jurisdiction.