Liquidated Damages: An Overview for Businesses
Contracts are the foundation of most business transactions, and they usually contain provisions that specify what happens if one party fails to fulfill their obligations. One of these provisions is the liquidated damages clause, which is designed to provide certainty about the amount of damages to be paid if a breach occurs. However, the enforceability of these clauses is not always clear-cut, and small to medium businesses in Illinois should be aware of the legal requirements and potential pitfalls of using liquidated damages in contracts.
What Are Liquidated Damages?
Liquidated damages are a specific sum of money agreed upon by the parties to a contract as compensation for a breach of contract. They are meant to be a reasonable estimate of the damages that would result from the breach, and they are often used in situations where the actual damages would be difficult to quantify or prove. Liquidated damages clauses are commonly used in contracts for the sale of goods, the provision of services, or the construction of a project.
Illinois Contract Law Requirements for Enforceability
Under Illinois law, a liquidated damages clause is enforceable if it meets certain requirements. First, the amount of damages specified in the clause must be a reasonable estimate of the actual damages that would be suffered by the non-breaching party if a breach were to occur. This means that the damages must be based on the circumstances that existed at the time the contract was formed, and not on future events that were not foreseeable.
Second, the liquidated damages clause must be clear and specific, stating the exact amount of damages that will be paid if a breach occurs. This requirement is meant to ensure that the parties know exactly what the consequences of a breach will be, and to avoid ambiguity or confusion.
Third, the damages must be difficult to ascertain at the time the contract is formed. This requirement is designed to ensure that the liquidated damages clause is not a penalty, but rather a reasonable estimate of the damages that would result from a breach.
Fourth, the liquidated damages must not be a substitute for performance. In other words, the non-breaching party must still be entitled to receive the performance that was promised in the contract, in addition to any damages awarded under the liquidated damages clause.
Fifth, the liquidated damages clause must not violate public policy. This means that the damages specified in the clause cannot be so excessive or disproportionate to the actual damages suffered that they are deemed to be punitive or unconscionable.
When Are Liquidated Damages Unenforceable?
Even if a liquidated damages clause meets the legal requirements for enforceability, it may still be challenged by the breaching party. The most common challenge is that the liquidated damages are actually a penalty, rather than a reasonable estimate of the damages that would result from a breach.
If the liquidated damages are found to be a penalty, the clause will not be enforced, and the non-breaching party will be limited to recovering only the actual damages suffered as a result of the breach. The determination of whether the liquidated damages are a penalty is a question of fact, and will depend on the specific circumstances of each case.
Another challenge to liquidated damages clauses is that they are ambiguous or uncertain. For example, if the clause does not specify a completion date for a construction project, it may be impossible to determine when the liquidated damages begin to accrue.
Because liquidated damages are complicated, small to medium businesses in Illinois should consult a business attorney to ensure that a liquidated damages clause is enforceable. At Imeri Rogers, LLP, our business law attorneys can help advise small to medium businesses on contract disputes, including disputes over liquidated damages. Our attorneys can assist businesses in drafting contracts with enforceable liquidated damages clauses, or challenge the enforceability of a liquidated damages clause in a contract dispute. Contact us today to discuss your legal needs.