Liquid

We sure do hear a lot about liquid these days - stock markets, personal investment portfolios, the Everglades water table, county water restrictions. This liquid theme inspired me to discuss the liquidated damages provision found in many contracts (based solely upon word association).

Many service contracts contain a liquidated damages provision. It typically provides that unwarranted termination or breach will result in the breaching party paying an agreed to amount as liquidated damages to the other party instead of suing for breach of contract and trying to otherwise ascertain the damages occasioned by the breach.

Why would a contract contain such a provision? Well, as I pointed out above, these clauses are usually found in service contracts where (unlike contracts for the sale of 4,000 widgets at $5.00 a piece) ascertaining the exact value obtained from the provision of a service can be difficult to calculate. In fact, that's the hallmark of a liquidated damages provision- the difficulty, if not impossibility, of determining what the true value of any damages caused by a breach would be.

Agreeing to such a provision assists in lending predictability to the parties' contractual dealings. If something goes wrong, both parties know exactly what the outcome should be down to the penny.

There is, however, an important limitation to the liquidated damages provision. Because it is intended to streamline the parties' relationship and provide predictability where there might otherwise be none, the value of the liquidated damages cannot be tantamount to a penalty. It is improper to insert a liquidated damages that would penalize the breaching party for breaching the contract instead of trying to approximate fair compensation.

Let's give an example. Suppose you have a contract to paint Bob's house. You can fairly estimate that it will cost $2,000 in paint and supplies and about 15 hours of labor (at $35.00 per hour) to paint Bob's house. This is a contract that would be perfect for a liquidated damages provision. You could, in the interest of expediency, include a liquidated damages provision for $2500 (the cost of paint, supplies and estimate of labor). You could not include a provision for $100,000 - this would clearly be a penalty wholly out of proportion to the contract's value.