Difference Between Liquidated Damages and Penalties

The difference between liquidated damages and penalties is that liquidated damages are the approximated amounts that parties designate during the implementation of a contract to act as security for the affected party to collect as compensation upon a specific breach while on the other hand, penalties are the sum determined by parties in a contract to be paid in case there is a breach and it is usually higher than the damage likely to occur.

Liquidated damages are usually applied in instances where the damages are not tangible. It’s the average cost of the damage likely to occur since it is usually proportionate to the damage that occurs.

Its purpose is to increase security and avoid legitimate costs of determining damages later on in case the contract is breached. They are fair compensations.

Penalties are the hefty amount put aside to prohibit any form of contract breach. They are usually larger than the damages likely to occur. Therefore, it is a punishment for a breach of contract.

It compels the parties involved to perform the contract. If not, they will be liable for the amount put aside as a penalty.

Comparison Table Between Liquidated Damages and Penalties

Parameter of ComparisonLiquidated DamagesPenalties
MeaningApproximate amount put aside to be paid in case there is a contract breachHefty amount to be paid in case of a breach of contract
Loss estimationProportionate to the damage likely to occurNo approximation  
ObjectiveDetermine the maximum amount of compensationCompel parties to perform the contract
ImpositionCompensationPunishment
OrderPays actual damage amount as per specifiedPays larger amounts than the actual damage that has occurred

What are Liquidated Damages?

These are the approximated fixed amounts that parties designate to act as a security and be paid as compensation in case there is a breach amongst the parties involved.

Its main objective is to determine the maximum amount of compensation if there is a breach. It is usually fair and proportionate to the damage likely to occur. Its purpose is to increase certainty and avoid legit costs of specifying damages later on in case of a breach.

It is a form of fair compensation-not too high or too low. It’s applied where damages are not tangible. When the damages are not pre-determined in case of a breach, they’re termed “at large” and determined by a tribunal.

The authority for the proposition that averaging is the appropriate approach in case of a breach may be taken from the Case of English Hop Growers V Dering 2KB 174 (A1928). This supports the liquidated damages clause.

It is an estimation of the loss likely to occur in case there is a breach and it determines the maximum compensation for the damage. It’s paid in the actual amount as per specified.

What is a Penalty?

It is the large sum determined by parties in a contract to be paid if there is a breach. It’s usually larger than the damage likely to occur. Its main objective is to compel the parties involved to perform the contract without fail for one not to pay the penalty as a punishment.

It is a form of contract security and prohibits the parties from absconding from the contract. Therefore, it does not put into consideration the estimation of the loss likely to occur.

It is usually large and unreasonable compared to the maximum loss. The amount is more than the one to be paid. By this, the parties will have no choice but to undertake the contract. It’s a punishment for a breach.

When penalties have been imposed on contracts, there are minimal or no breaches of contracts because the amount is usually too high. Therefore, it will compel the parties to perform the contract without fail.

When there is a contract breach, the parties pay the amount without putting into consideration the specified area where the contract has been breached. This means, whether part of the contract or the whole contract has been breached, the amount payable is equal.

Main Differences Between Liquidated Damages and Penalties

  1. Liquidated damages are the approximated amounts to be laid to an injured party in case there is a contract breach while a penalty is a hefty amount to be paid in case there is a breach and it is larger than the damage likely to occur.
  2. Liquidated damages are usually in actual amount as specified by the contract while penalties are paid irrespective of whether part of the contract or the whole contract has been breached.
  3. Liquidated damages are used to determine the maximum amount of compensation in case there is a contract breach while penalties are imposed to compel the parties to perform the contract without fail.
  4. Liquidated damages are forms of compensation while penalties are punishments.
  5. Liquidated damages are proportionate to the damage likely to occur while penalties have no approximation.

Conclusion

Liquidated damages and penalties are both amounts paid in case there is a breach of contract. In liquidated damages, the parties pay an approximate amount close to the damage that is likely to occur while in penalties, the parties pay a larger amount than the damage likely to occur.

Therefore, in case there is a contract breach, there is compensation for the damage that occurred or a punishment for the damage that has occurred.

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