In the United States, a liquidated damages clause is intended to estimate damages in the event of non-performance or breach of contract. Such a clause will be enforced where the court finds that the harm caused by the breach is difficult to estimate, but where the amount of liquidated damages is reasonable compensation and not disproportionate to the actual or anticipated damage. The intent of liquidated damages is to measure damages that are hard to prove once incurred.
However, if the liquidated damages are disproportionate, they can be declared a penalty. The clause is then void, and recovery will be limited to the actual damage that results from the breach.
In the US, courts generally consider two elements to determine whether a liquidated damage clause is enforceable: whether the harm caused by the breach is difficult to calculate; and whether the amount of the liquidated damages is reasonable in proportion to the actual or anticipated harm. If it is not, then it is a penalty, therefore the clause is unenforceable.
Most other common law countries such as England, Australia, Ireland and Canada have similar rules and do not allow for liquidated damages that are used as a penalty.
It is more difficult to find a consistent application of the concept of liquidated damages or other contractual “penalties” in civil code countries in the international marketplace. In some countries, whether under civil code or doctrine or case law, both concepts are recognized and the terms are used interchangeably.
An agreement between parties of a contract to pay a certain sum in the event of non-performance is generally allowed, whether as a penalty or compensation. However, the amount can be reduced by the courts if it is “substantially disproportionate to the actual loss.”
