The Difference Between Penalties and Liquidated Damages

Suppose you hire me to build you a factory. We sign a contract that says I will finish it by a certain date, and if I miss that deadline, I will pay you $1,000 for every day that I am late.

Well, let’s imagine things go badly (for me) and I deliver the factory many days late. The contract says I owe you some money. But I don’t want to pay, so you deduct it from your final payment to me. I’m not happy, and so I sue you to get it back. When we get to court, what the Judge really wants to know is why we agreed to the $1,000-a-day payment in the first place. Depending on the reason, I may or may not get my money back.

There are two possible explanations for the $1,000-a-day payment.

First, it might be that the payment is intended to punish me for being late. The risk of losing $1,000 a day was meant to motivate me to meet the deadline. It was the stick that was supposed to keep me on track and on time. In legal terms, it’s a penalty.

But the law frowns on penalties. With a few exceptions, penalties by themselves are not enforceable between private parties. In our case, the Judge would not likely allow you to keep the money just because I missed the deadline – if it is a penalty. Rather, you would have to prove that you actually suffered some loss because I was late, and then your claim would be the amount you actually lost.

But there is another explanation for the $1,000-a-day payment. As reasonable business people you and I could see that missing the deadline would likely cost you money. You realized that proving that loss would consume even more time and money. I realized that I faced an open ended claim. But by agreeing ahead of time on the amount of compensation, we both controlled the risk. In legal terms, we “liquidated the damages” by genuinely pre-estimating your likely losses. In other words, we agreed on liquidated damages.

Unlike penalties, the law upholds contracts that award liquidated damages. There are good reasons for this. First of all, such contracts allow both sides to plan with certainty: we know and control our risks and our downside Second, our legal system (at least when it deals with rights and obligations between individuals, rather than criminal matters involving the state) strives to compensate victims rather than punish wrongdoers. Liquidated damages serve the goal of making you whole, not making me suffer.

And third, pre-estimating your loss is efficient and cost-effective. The process of quantifying and proving losses is often the most difficult, time-consuming, and costly part of a delay claim. It can involve competing teams of accountants, actuaries, engineers, and claims consultants, not to mention all the internal resources we both would have to devote to the task. Agreeing on a number ahead of time benefits everyone.

So, courts will enforce liquidated damages but not penalties. But how will a Judge tell them apart? Finding the words “Liquidated Damages” in the contract is helpful, but not really determinative: calling something by a name does not always make it so. Nor is the after-the-fact testimony of the parties all that reliable (or even admissible), since our reasons and interests may have changed since we signed the contract.

The better evidence is how closely the $1,000-a-day payment matches what reasonably could be predicted at the time the contract was signed. The goal is not to use hindsight nor to be exact, but to go back and look at things as they appeared at the beginning. In other words, was it a pre-estimate and was it genuine?∎

This post is meant to provide information only and is not intended to provide legal advice. Although every effort has been made to provide current and accurate information, changes to the law may cause the information in this post to be outdated.