Liquidation provisions in a contract entail the payment of a predetermined sum as compensation when a contractual breach occurs.
These liquidation provisions are alternatively referred to as liquidated damages clauses. Poorly drafted, this clause could result in substantial litigation and legal complications, contrary to its intended purpose. It is advisable to opt for a more standard clause where the parties mutually specify the damages and agreed-upon amount in the event of a delivery delay.
An example of a liquidated damages clause:
“If the seller breaches their obligations as outlined in this agreement by failing to deliver goods or services according to the mutually agreed-upon schedule, the buyer shall be entitled to recover a daily amount of AED as liquidated damages for each day of delay.”
Parties in a contract include such provisions to prevent disputes over the amount of damages, which can be costly when taken to court, involving legal fees and extensive discovery processes.
Liquidated damages clauses also resolve disputes related to mitigation. With this clause, a breaching party cannot argue for a reduction in damages or claim that the aggrieved party failed to mitigate, ensuring predictability as intended.
A liquidated damages clause often becomes a focal point in litigation when defaults occur later on, with one party finding it excessive.
Various issues arise from liquidated damages clauses, leading to different drafting techniques that parties should consider when negotiating the terms of such provisions. These issues include:
Exercising caution in the drafting of optional liquidated damages clauses is advisable. In cases of litigation, a party that breaches an agreement can contest the validity of an optional liquidated damages clause and the buyer’s choice to invoke it. While certain courts have upheld the enforceability of optional liquidated damages clauses for sophisticated parties, the prevailing consensus leans toward their unenforceability.
Courts may invalidate such clauses if they appear to lack reasonable attempts to estimate potential losses. Consequently, it is prudent to refrain from incorporating an optional liquidated damages clause altogether.
If there is a genuine necessity for such a clause, consider including the following provision:
“If the liquidated damages clause within this agreement is deemed to function as a penalty due to its allowance for the aggrieved party to invoke it, the parties mutually agree that the liquidated damages provision shall apply, rendering the option null and void.”
Detailing the Damages Parties Intend to Liquidate
Parties often overlook the importance of specifying the types of damages they intend to liquidate. For instance, let’s consider a hypothetical scenario where a widget manufacturer serves as the seller, and the buyer is responsible for distributing the widgets. The manufacturer’s delays can potentially disrupt the wholesaler’s downstream operations, resulting in reputational damage. In addition, the wholesaler might incur costs associated with compensating its customers, who are the retailers.
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On the other hand, a delay by the manufacturer could also lead to the wholesaler losing its ability to resell products to retailers. These two types of damages have distinct consequences, underscoring the need for careful deliberation when drafting a liquidated damages clause. It becomes crucial to specify the precise losses that will and will not be subject to liquidation.
To address the aforementioned scenario, parties may include a clause similar to the following:
“The liquidated damages clause outlined herein is intended to cover reputational losses and other losses incurred or anticipated by the buyer if the seller’s delay does not result in the buyer losing the ability to resell widgets. The provision for liquidated damages shall not apply if the seller’s delay leads to the buyer losing sales on existing contracts.”
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Under what circumstances is a liquidated damages clause permitted?
A liquidated damages clause may be deemed valid under the following conditions:
1. When the damages or losses resulting from a contract breach are uncertain.
2. When it is challenging to establish the precise amount of damage or loss.
3. When the specified amount in the liquidated damages clause is reasonable and equitable.
4. When there are no alternative remedies available to cover the damages.
5. When the damages are intended to serve as protection against a breach of contract rather than as a penalty for such a breach.