If you have some experience with contracts, you’ve likely heard the phrase “liquidated damages.” While this term might sound mysterious to many people, the concept is relatively easy to understand. Liquidated damages are basically an agreed-upon amount of money that a party to a contract will be required to pay in the event that the party breaches the contract.
Use of a liquidated damages provision can be effective at avoiding costly disputes over how much financial harm was caused by a breach of contract. However, these provisions are not always enforceable and should be crafted with care.
What’s the Problem?
The crux of a liquidated damages provision is that it is to be used in a situation where you can’t easily determine what “actual damages” would be caused by the breach. So, to avoid the difficult exercise of proving actual financial harm, the parties will stipulate to an amount that they think is reasonable.
For example, let’s say that a shopping center rents a space to a tenant to operate a business. The lease requires the tenant to be open for business every day. The parties understand that, if one tenant in the shopping center “goes dark” and is not operating, the shopping center as a whole will be less vibrant, have less customer traffic, and be less profitable. The parties also understand, however, that – if one business in the center violates the agreement by not continuously operating – it will be very difficult to establish exactly how much money was lost by the shopping center. Therefore, the parties agree to an amount of liquidated damages that will be imposed in the event that a tenant stops operating, so that the center is not required to provide evidence of its actual financial damages (which may be impossible to calculate).
The trick with liquidated damages provisions is that their enforceability is often subject to debate. If the liquidated damages are not reasonable, then a court may deem them to be an unenforceable “penalty.” As stated by North Carolina courts: “A stipulated sum is for liquidated damages only (1) where the damages which the parties might reasonably anticipate are difficult to ascertain because of their indefiniteness or uncertainty and (2) where the amount stipulated is either a reasonable estimate of the damages which would probably be caused by a breach or is reasonably proportionate to the damages which have actually been caused by the breach.”
Notably, in the context of the shopping center lease described above, a North Carolina appeals court recently upheld a liquidated damages provision that required the tenant to pay double rent for each day that its business was not operating. The tenant did not show that the amount was unreasonable, according to the court. But what if the provision called for triple rent? Quadruple rent? Perhaps the outcome would have been different.
Use These Provisions Carefully
Liquidated damages provisions appear in a variety of contexts, addressing issues that range from delays on construction projects to buyers backing out of real estate deals. These provisions can be very useful. But before inserting a liquidated damages provision in a contract, significant thought should be given to whether the provision is necessary and reasonable. If a party could easily determine its actual financial losses in the event of a breach, liquidated damages are probably inappropriate. Furthermore, the amount of liquidated damages should be carefully developed on a case-by-case basis. Otherwise, a seemingly favorable liquidated damages provision may wind up being the subject of litigation – and ultimately may not be enforceable.
Elliot has practiced law for over 20 years and is a member of the Federal, North Carolina and Forsyth County bar associations. He is an experienced litigator with major case experience in state and federal courts and in private arbitrations. Elliot also has a broad range of experience with landlord-tenant law and has assisted many of North Carolina’s premier shopping centers.