Liquidated Damages: Protecting Your Franchise's Good Name
By Al DeNapoli Partner, Tarlow Breed Hart & Rodgers, P.C. | October 2008
Cicero tells the story how in ancient Syracuse, Damocles gave back the throne to the reigning king when he realized the king had perched above him a sword hanging from a fine thread. Liquidated damages, in some instances, work like the proverbial "Sword of Damocles": hovering above the parties as a threat in case of a breach of contract.
While the law in each state differs as to the use and acceptance of liquidated damages, the most widely-used basis for a generic explanation of the concept of liquidated damages comes from the Restatement of the Law: Contract Second:
Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing an unreasonably large liquidated damage is unenforceable on grounds of public policy as a penalty. (p. 157)
When entering agreements in which you believe you may not be able to easily assess damages that may be caused by a breach, and/or you wish to keep the other party focused on the amount of damages it may face if it fails to perform, liquidated damages can be a valuable tool and "weapon". Unlike the "Sword of Damocles", however, liquidated damages are, in many instances, a double edged sword. Especially be careful in those instances where they are used clearly more as a sword to punish than a shield to protect. As set forth above in the Restatement, most courts will strike them down in those instances as an unenforceable penalty.
Courts in most jurisdictions, when reviewing a claim for breach of contract and are faced with a liquidated-damages clause in the contract allegedly breached, will examine in the first instance to see whether the liquidated damage clause results in reasonable compensatory damages or whether in fact the liquidated damages are tantamount to an unreasonable penalty.
Contract damages are not meant to be punitive, but instead to be compensatory. Generally, when a contract is breached, courts look mainly to compensate the party against whom there was a breach for the damages it suffered as a result of the breach. If in fact the damages are too speculative and/or incapable of determination, the courts will not award damages. Often, to avoid this situation, among other reasons, contracts will contain a liquidated damage clause.