Background on how to draft a liquidated damages clause

In our article, we address how to draft a liquidated damages clause. Liquidated damages clauses have evolved as business lawyers draft contract terms for their client companies. Contract law, in general, is based on mechanisms developed and demanded by business life. Contract law is thus practical law. From a business perspective, a liquidated damages clause increases the predictability and legal certainty of contracts.

Predictability is based on the predictability of compensable damages. Liquidated damages are used in situations where predictability is desired for compensation. In addition, the use of the clause is recommended in situations where the damage is difficult to predict, define, or prove.

The use of a liquidated damages clause often strengthens the position of a potential creditor and thus enables the formation of a contract between the parties. The potential debtor can be understood to provide security for the potential creditor with a liquidated damages clause, thus enabling the formation of a contract between the parties. The clause facilitates and eliminates uncertainty in the contractual relationship, enabling the formation of a contract in an uncertain situation.

Considerations when using a liquidated damages clause

When drafting a liquidated damages clause, many factors affecting the contractual relationship must be taken into account. Naturally, it is not possible to address all of them here, but here are a few. Determining the time for calculating default interest is one such consideration. When using the clause, it is advisable to determine from which point in time default interest should be calculated.

In supply chains or contractual chains, it is essential to determine whether the liquidated damages concern direct or indirect damage. This is especially true when one party imposes liquidated damages on its own contracting partner due to a breach of contract by the other party. In a Supreme Court decision (KKO 2014:61), it was concluded that late fees were considered indirect damage, and the claim presented in the case was dismissed.

Because liquidated damages are typically used in situations where the achievement of the other party’s goal for the contract is desired to be secured and emphasized (loyalty principle), the pressure function of the other parties is crucial when using the clause.

Finally, it should be noted that the reasonableness of the liquidated damages should be given weight when drafting the clause. The Finnish legal system provides means to address unreasonable contract terms.

When using a liquidated damages clause in international trade or carriage contracts, the specific requirements of these legal areas, such as the mandatory nature of legislation, must be considered. Additionally, different legal systems treat the clause differently. Therefore, attention should also be paid to the law applicable to the contract.

Liquidated damages clauses in standard terms: YSE 1998 | How to draft a liquidated damages clause

Widely used in the construction industry, the YSE 1998 terms contain a standard compensation clause in section 18. In case of a delay in the work, the client has the right to receive liquidated damages from the contractor. The client is not entitled to any other compensation unless the contractor has acted intentionally or with gross negligence.

The clause is a notable example of how a liquidated damages clause can be formulated for the contractor’s delay. The ongoing liquidated damages are conducive to pressuring the debtor to perform the contract. Additionally, the pressure function of the delay is clearly evident from the clause. It should be noted that the scope of the clause’s use is reduced by the fact that the client’s omissions affect the delay. In such a situation, the contractor typically receives an extension of the contract period.

Why use a liquidated damages clause in a contractual relationship?

In situations where the behaviour of the contracting parties is strongly guided by individual goals, the special need for protection provided by the liquidated damages becomes prominent. The clause aims to secure the loyalty of the parties to their goals. Such situations are particularly evident in confidentiality and exclusivity agreements, franchise agreements, and similar collaboration agreements. In the aforementioned contracts, individual goals are emphasized.

The use of liquidated damages eliminates the problems of proving the defaulting party’s fault in litigation (evidence). Fault involves negligence or intent. In addition, uncertainties regarding the proof of contract breaches are reduced and partially eliminated when using the clause.

On the effectiveness of the liquidated damages clause | How to draft a liquidated damages clause

In several Supreme Court decisions (KKO 2001:27) and (KKO 1995:204), it has been stated that there have been no grounds for moderating liquidated damages. In the first decision, a liquidated damages of 154,000 Finnish marks was imposed for the sale of real estate. The purchase price in the case was 485,000 Finnish marks. Therefore, even high liquidated damages clauses have been considered acceptable in legal practice. For this reason, the use of these clauses is effective and ensures the achievement of the intended goal quite efficiently. Thus, the clause effectively secures against contract breaches. Therefore, there are strong grounds for using it in certain situations.

Regarding this topic, our experts Liene Krumina and Oscari Seppälä are happy to respond to specific questions and discuss the possibilities of using a liquidated damages clause in your business contracts. Get in touch!

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** The article is for information and not as a legal advice.