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Business deals made with a firm handshake and the other party’s word are long gone. Today, savvy businesses prefer to protect themselves with ironclad contracts, but the fine print is important. Two clauses may apply in the event of a breach of contract – liquidated damages vs. penalty clauses – and there are distinct differences between them.

What is the difference between a liquidated damages clause and a penalty clause? Below, our Phoenix breach of contract attorney shares why businesses should draft liquidated damages clauses for contracts instead of mistakenly including an unenforceable penalty.

Liquidated Damages vs. Penalty Clauses: What is the Difference?

Your business signs a contract with Company B that says they will deliver 100 widgets to you by a certain date. Due to unexpected circumstances, Company B breaks this agreement by failing to produce your widgets by the agreed delivery date. Here is where the contractual breach clauses kick in.

Liquidated damages and penalty clauses aim to safeguard your business from actual harm and foreseeable losses. How do liquidated damages vs. penalty clauses compare in practice? Learn more below.

What Is a Liquidated Damages Clause?

A liquidated damages clause seeks monetary payment to counter any potential loss. Typically, the clause states that the breaching party must pay a fixed sum for their failure to uphold the terms of a contract. It may include a genuine pre-estimate for compensation to protect the non-breaching party in the event of likely loss. 

Here is an example of a liquidated damages clause: 

John signed a contract that said he would deliver 15 machines to Amy by December 14. If he misses the due date, the clause states that he will pay Amy $500 for the potential losses incurred. John intended to uphold the agreement, but when unforeseen circumstances made him miss the deadline, he instead made a payment of $500 to Amy in lieu of the delay.

Another reason that a liquidated damages clause is appealing is because the parties do not have to go to court to settle their dispute. How do liquidated damages vs. penalty clauses compare in this regard?

What Is a Penalty Clause?

While liquidated damages clauses compensate parties for potential losses, penalty clauses are punitive. The contract designs a penalty clause to punish a party in the event of a breach. As with a liquidated damages clause, one party must pay a fee to the other if the penalty clause takes effect.

While they are similar ideas meant to compensate the contracted party who has suffered a loss, the main difference between liquidated damages vs. penalty clauses is the intent. Penalty clauses charge fees that are not proportionate to the damages they cover because, after all, charging a fee simply to cover actual damages would not teach the contract breacher a lesson. For this reason, a penalty clause is often excessive and unreasonable. 

Here is an example: 

Heidi’s apartment lease is up at the end of the month, but due to various factors, she cannot find a new place to live. The rental agreement includes a note that the landlord will charge $300 for each day that Heidi stays beyond her lease. The landlord insists this is a reasonable amount, but would that claim hold up in court?

What about a business owner who charges a percentage-based fee that increases every day a delivery is late and does not place a cap on the fee in the contract? Such a clause could end up costing a non-delivering supplier big – if it is enforceable.

Are Penalty Clauses and Liquidated Damages Enforceable?

Under U.S. law, penalty clauses are generally unenforceable in court. They usually include outrageous consequences rather than a genuine pre-estimate of actual damages. The court frowns upon a non-breaching party who includes an unreasonable penalty provision in a contract, so you  will have much more support in enforcing a contract with a reasonable liquidated damages provision instead.

Generally, as long as the fee is not deemed excessive, it holds up. Is your clause meant to secure performance rather than punish other parties? The court will likely uphold the contract. 

Speaking with a contract lawyer will assist you in making sure you only include reasonable, enforceable clauses and eliminate unenforceable ones. Here is what to look for when comparing liquidated damages vs. penalty clauses:

The Obligation To Pay the Amount Requested Is a Secondary Obligation

The contract’s primary obligation is what the other party is supposed to do for you in the contract. The secondary obligation outlines how that party will compensate you if they breach the terms of the agreement. Delivering 10 items to you by a set date represents the main obligation, whereas paying you $1,000 if the party fails to deliver is only a secondary consideration, so it must directly relate to the primary obligation.

The Innocent Party Has a Legitimate Interest in the Specific Performance of the Contract

Legitimate interest must underpin your contract. For example, you may need those 10 items mentioned above for a trade show on a certain date, so a breaching party missing that due date will cause you to miss the trade show or other negative consequences. If the non-breaching party’s contractual provision is not covering a situation where damages will occur as a result of the breach, then the court may deem it a penalty clause making it unenforceable.

The Sum Is Reasonable, Not Intended as a Punitive Measure, and Representative of an Actual Loss Suffered

If the stated damage amount for a breach of contract is a genuine estimate of actual damages suffered, you can then claim that you made the estimate in good faith. There is some wiggle room here as to what is deemed a reasonable estimate. A fee of $5,000 might constitute an excessive penalty, but if the consequences for breaching the contract are severe (a delivery of life-saving medication, perhaps), this fee might be perfectly justifiable.

Do You Need To Draft Liquidated Damages Clauses or Another Enforceable Contractual Provision? Avoid the Common Pitfalls and Contact Anthony Law Group

The difference between liquidated damages vs. penalty clauses is airtight contract creation. Attorneys at Anthony Law Group handle all types of contract breaches, including unfair penalty clauses, so if your business has suffered due to a contractual breach, there may still be hope.

Contact Anthony Law Group at (602) 362-2396 today to learn more.