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Liquidated damages clause

liquidated damages / early termination fee clause / penalty clause in a contract

In short

A liquidated damages clause sets, in advance, the amount or formula one party owes the other if it breaks the contract. Courts generally enforce one only when the figure is a reasonable estimate of harm that is hard to prove, and refuse one that works as a penalty.

Cornell's legal encyclopedia describes liquidated damages as an exact amount of money, or a set formula, that a party will owe if it breaches a contract. They must be clearly stated in the contract and agreed before it is signed. Parties use them where actual damages are real but difficult or impossible to prove.

The limit is reasonableness. The Uniform Commercial Code governs sales of goods. It allows damages to be liquidated only at an amount reasonable in light of the expected or actual harm, how hard the loss is to prove, and how hard an adequate remedy is to get otherwise. A term fixing unreasonably large liquidated damages is void as a penalty.

Courts apply the same instinct more broadly. Cornell's entry says courts will not impose liquidated damages if the clause is punitive, illegal, unconscionable or contrary to public policy. It also notes the clauses can be used to discourage a party from breaching, which is where the line with a penalty gets tested.

In practice

A 24-month marketing agreement at $3,000 a month says that ending it early costs 100% of the remaining fees. A business leaving after 6 months would owe $54,000 for 18 months of work nobody will do. A clause set at two months of fees, tied to the agency's cost of reassigning staff, is far easier to defend as a reasonable estimate of harm. Whether a court enforces either depends on the facts and the state's law. The figures are a worked example.

Why it matters to you

An early termination fee in a service contract can be written as liquidated damages. The number is set before anything goes wrong, when it seems unlikely to matter. Before signing is when the business has the most say over it, so that is the time to ask what harm the figure estimates.

What to ask or check

  1. 01What loss is this amount meant to estimate, and how was it calculated?
  2. 02Does the amount shrink as the contract runs, or stay fixed until the last month?
  3. 03Is there a cheaper way out, such as notice, a shorter term or a capped fee?

What people get wrong

That any number written into a contract as damages will be enforced. Courts will not impose liquidated damages if the clause is punitive, and the Uniform Commercial Code says a term fixing unreasonably large liquidated damages is void as a penalty.

Red flags

  • A cancellation fee equal to every remaining month of a contract, with no link to what leaving early actually costs the other side.

Keep reading

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Uptime guarantee

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Trademark

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Consumer Review Fairness Act

The Consumer Review Fairness Act voids contract terms that stop customers reviewing you. A provision of a standard-form contract is void from the start if it bars a review, penalizes one, or takes the reviewer's intellectual property. Removing abusive or irrelevant content is still allowed.

Typical results

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