Liquidated damages and penalty are two terms that are often associated with contract law. Both these terms are related to the legal remedies available to parties who suffer losses due to breach of contract. However, there is a significant difference between the two concepts that is important to understand.

In contract law, liquidated damages refer to a pre-determined sum of money that is agreed upon by both parties at the time of contract formation. This sum of money is meant to compensate the non-breaching party in case the other party breaches the contract. Liquidated damages are typically used when it is difficult to estimate the actual damages that may occur due to a breach of contract. For example, if a construction company agrees to complete a building within a certain time frame and fails to do so, the owner of the building may suffer damages such as loss of rental income or additional costs for alternative accommodation. In such cases, the parties may agree upon a fixed sum of money that the construction company will have to pay if they breach the contract.

Penalty, on the other hand, refers to a sum of money that is intended to punish the breaching party rather than compensate the non-breaching party. Penalty clauses are generally considered unenforceable in contract law as they are seen as a way for the non-breaching party to extract undue advantage from the breaching party. In other words, penalty clauses are viewed as a form of “punishment” rather than compensation. For example, if a salesperson fails to meet their sales target, the employer may include a clause in their contract that requires them to pay a penalty of $10,000. In such cases, the penalty is likely to be seen as excessive and unfair, and may not be enforceable in court.

It is important to note that, in order for a liquidated damages clause to be enforceable, it must meet certain criteria. Firstly, the damages must be difficult to estimate at the time of contract formation. Secondly, the amount of damages must be reasonable and proportionate to the loss that is likely to be suffered by the non-breaching party. If the liquidated damages clause is found to be unreasonable or excessive, it may be interpreted as a penalty clause and be unenforceable.

In conclusion, while liquidated damages and penalty clauses are both related to contract law, they serve different purposes. A liquidated damages clause is meant to compensate the non-breaching party for damages suffered due to a breach of contract, while a penalty clause is intended to punish the breaching party. It is important to ensure that any liquidated damages clause included in a contract meets the criteria set out in contract law in order for it to be enforceable.