Importance of Liquidated damages clause in a contract

All commercial agreements begin with the premise that each
party to the agreement will honour its respective obligations under the
agreement.

However, this is not the case many a times.

If all parties were able to or willing to honour all their
obligations, a significant number of lawyers would be out of business.

While providing remedies for non-performance or breach in a
commercial contract, a liquidated damages clause can be quite useful. By
“Liquidated damages” we mean damages whose amount the parties to a
contract quantify and designate during the negotiation of a contract for the
non-breaching party to receive as compensation upon a specific breach (e.g.,
non-performance, late performance or inadequate performance).

Such a clause in a contract helps in reducing ambiguity on
the subject matter. The parties can save on a lot of time, money and energy on
potential disputes in this regard. A Liquidated damages clause specifies the
amount of damages to be paid by the breaching party if it fails to perform
specified obligations and otherwise in the event of certain types of breaches
under the contract.

The amount agreed as liquidated damages represents the
estimate of the parties regarding the likely / anticipated or actual damages
suffered by the non-breaching party in the event of a specified breach of the
contract by the other (breaching) party.

In most of the cases, the parties agree to liquidated
damages in cases where calculation of the actual damages suffered by the
non-breaching party is difficult or time consuming. Thus, the contracting
parties agree to an amount deemed reasonable and a good estimate of such
damages by them.

While upholding claims of a non-breaching party, a court is
also likely to go into the reasonability of the amount agreed as liquidated
damages.

Typically, a liquidated damages clause includes the
following:

• The reason for specification of liquidated damages
• List of breaches exposing the breaching party to
  liquidated damages
• The amount of liquidated damages (in a specified
  currency)
• Alternatively, a calculation method to ascertain the
  liquidated damages (amount slabs, percentages, etc.)
• Confirmation of the parties that they understand and
  appreciate the reasons and that the amount / formula for liquidated
  damages is reasonable
• Whether the quantified liquidated damages are the only
  remedy available to the non-breaching party or are there any other
  cumulative remedies.

The importance of liquidated damages cannot be undermined as
in case of a default, enforcement is not dependent on actual damages suffered
by the affected party. The courts too favour the aggrieved party, unless
evidence to the contrary (e.g., self-inflicted damage) can be demonstrated.

Happy drafting!

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Bhumesh Verma is a lawyer with over 2 decades of experience in advising domestic and international clients on corporate transactions (M&A, Venture Capital, Private Equity, Startups, corporate advisory, etc.) and features in “The A-List – India’s Top 100 Lawyers” by India Business Law Journal. He keeps writing frequently on FDI, M&A and other corporate matters and is a guest faculty as well. He can be reached at bhumesh.verma@corpcommlegal.com.