What is a Liquidated Damages Clause in a Contract?

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What is a Liquidated Damages Clause in a Contract?

One of the ways to help reduce risk in a commercial contract is the inclusion of a liquidated damages clause that specifies an estimated payment for any resulting damages from a breach of that contract. Once the types of breaches are defined in the contract terms, the monetary damages to be set are the parties’ best estimate at the time the contract is executed.

While there are advantages to a liquidated damages clause, these clauses are not always enforceable. Liquidated damages clauses are more likely to be enforceable if actual damages are too difficult to estimate, and the damages amount is fair and reasonable.

To be effective, a liquidated damages clause should include:

  • The types of breach that would trigger the liquidated damages clause.
  • The amount of liquidated damages in the event of a breach.
  • The reasons the contracting parties are agreeing to a liquidated damages clause.
  • The contracting parties’ intent that the amount of liquidated damages is a fair estimate of the actual damages that may occur in the event of a breach.
  • That the liquidated damages are the exclusive remedy of the non-breaching party.

An April 2017 Arizona Supreme Court ruling established a two-part test for the enforcement of a liquidated damages clause in Arizona. Under that test, liquidated damages can be deemed reasonable if they approximate either:

  • The loss anticipated at the time the contract is created; or
  • The actual loss that resulted from a breach.

The court also ruled that a non-breaching party does not have to prove actual damages for a liquidated damages clause to be enforceable. However, if a court determines that the liquidated damages amount was excessive or that it would have been easy to calculate actual damages at the time the contract was created, the court may void the contract.

In addition, a court may also take into consideration the bargaining power of both parties to determine if a liquidated damages clause is reasonable. They may invalidate the clause if one party has much greater bargaining power than the other.

When contract disputes arise, you need experienced legal representation and advice. Williams Mestaz, L.L.P., is a law firm focusing on contract law, bet-the-company cases, and business divorce. Contact us at (602) 256-9400 and schedule a time to meet with us today.

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