Liquidated damages are those pre-agreed damages that are included in an agreement and serve as a safeguard in the form of compensation at the disposal of an aggrieved party where the other party fails to perform.
An example of such a provision would be where Party A, as part of a private equity transaction, purchases shares in a company and in turn the company provides certain warranties, for instance, a debt to equity covenant. The damages suffered by the innocent party in the case of a breach of such a warranty is widespread and could prove to be difficult to calculate. In such a scenario it creates the ideal opportunity for the innocent party to insist on the insertion of a damages clause in order to relieve potential losses.
For liquidated damages to be enforceable, the liquidated amount should not be unreasonable and inappropriate by being unlimited and excessive. In the case of Hyprop Investments Ltd and Another v NCS Carriers and Forwarding CC and Another, the Court ruled that in order for the innocent party to succeed with a claim for compensation in terms of a liquidated damages clause, the pre-agreed damages should be proportionate to the actual and anticipated loss suffered by the innocent party. Liquidated damages should not be seen as a form of punishment, rather as an effective tool to implement when there is a breach of contract.
Criteria for pre-determined damages:
- the damages must have an element of uncertainty and complexity when dealing with the estimation thereof;
- the amount claimable for compensation should not be unreasonable and inappropriate in the relevant circumstances and consideration should be given to the actual loss suffered; and
- a distinction should be made between liquidated damages and penalties, as liquidated damages are not intended to serve as a penalty.
Liquidated damages provisions ensure that compensation is ready and at hand, not only ensuring payment towards the innocent party but furthermore eliminating any potential disputes that may arise in the future with regards to the value of the damage incurred. The use of these provisions provides some sense of certainty, serving as a form of insurance for the innocent party against possible loss. It is also a rapid and prompt manner for the aggrieved party to claim compensation in the event of the breach.
In practice, the absence of pre-agreed damages could lead to prolonged court applications and litigation. The innocent party bears the onus to establish that damages were suffered, the exact amount, and whether or not he/she is in fact entitled to compensation, which in turn could then be open for dispute by the defaulting party.
The application and underlying commercial considerations of the inclusion of liquidated damages, will, however, need to be considered on a case to case basis. The value of these provisions vests in the commercial benefit thereof. Liquidated damage amounts are determined beforehand by the parties, foreseeing any complications that might arise and having already secured a solution through the respective provision, saving the aggrieved party a substantial amount of time and of legal costs. The important feature of the pre-agreed liquidated damage is that it creates clarity and certainty and, although different in character, it operates in a similar manner as a “Break Fee”.