Liquidated Damages Provisions: A Good Idea?

In a contract, the parties may agree that damages for breach of that contract by a party shall be "liquidated."  This means that the parties decide in advance what the party that breaches the contract must pay to the non-breaching party as damages for breaching the contract.

Without a liquidated damages provision, the burden will be on the non-breaching party to prove the amount of damages that result from the breach of contract.  Often, it is difficult, if not impossible to prove the amount of damages that result from a particular breach of contract.

In California, a court cannot award damages that are "not clearly ascertainable in both their nature and origin." [Civil Code Section 3301.]  So, where damages are not easily ascertainable, a non-breaching party to a contract may find it impossible to recover damages in arbitration or litigation even if there is no dispute that the other party breached the contract.

In addition to making sure that damages can be awarded for a breach of contract, a liquidated damages provision may also be desirable by one or both parties because it sets the amount of recoverable damages for a breach of contract, instead of leaving the proof of damage amount as a separate matter to be litigated.  For this reason, a liquidated damage provision will often encourage settlement of a dispute prior to the filing of a lawsuit.

In most commercial contexts in California, liquidated damages provisions are enforceable and valid "unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made." [Civil Code Section 1671.]  Thus, a party seeking to invalidate a liquidated damages provision faces an extremely difficult burden to overcome, especially having had agreed to the liquidated damages provision in the first place.

In a business purchase agreement, it is common for a liquidated damages provision to apply with respect to a buyer breaching the contract by failing to complete the transaction as agreed.  Typically, the amount of the buyer’s deposit is adopted as the amount of liquidated damages.  This is convenient in that the deposit is usually held by an escrow company, which makes it easier for the seller to recover that sum upon the buyer's breach.

I typically recommend to both buyer and seller clients of mine to enter into such a liquidated damages provision.  A buyer that cancels a deal without a valid contingency knows that only his deposit is at stake and that he won't be exposed to expensive litigation regarding the amount of the seller's actual damages.

A seller that has had a buyer walk away from a deal without good reason at least knows that he's got damages already decided and being held in escrow, avoiding the need for expensive litigation, avoiding the risk that a judge will determine that damages cannot be awarded because they are uncertain, and avoiding the challenge of collecting damages if the court does, in fact, award damages.

About The Author: Joe Sandbank -  I assist buyers, business owners and brokers with all legal aspects of buying, operating and selling a business, from buyer representation to exit planning and everything in between. Call for cost-effective representation for your transactions (consulting, negotiations, letters of intent, due diligence, buy/sell agreements, entity formation, leases, financing, etc.) and disputes (negotiations, demand letters, litigation, arbitration, mediation). Phone Joe at 800-875-1480 for more information and a consultation.

Categories: BizBen Blog Contributor, Deal And Escrow Issues, How To Buy A Business, How To Sell A Business, Legal Topics