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In general, a liquidated damages clause sets a sum of money that the non-breaching party to a contract can collect if the other party breaks the agreement.  If you promise to train an employee in exchange for the employee’s promise not to quit for six months after training, you may agree in advance that either person will pay the other a fixed dollar amount if the promises aren’t kept. That’s a liquidated damages clause.

When is a Liquidated Damages Clause Useful?

Like any of the carrots and sticks employers use to keep valuable employees, a liquidated damages clause is not universally appropriate.  Clearly you would want to use it only for contract employees, not for the general mass of employees-at-will.  It usually comes up in connection with a non-compete agreement.  It’s also true that courts generally won’t enforce provisions that are simply penalties, and the particular hot-button issues vary from state to state. This is not a do-it-yourself project.  Ask your business attorney to draft this contract.

When these provisions get litigated the argument usually devolves into two questions:

  1. Did it make sense to decide on a sum of money in advance because calculating the actual harm from the breach was difficult or impossible?
  2. Is the sum of money involved proportionate to the loss suffered?

When is Setting a Damage Amount in Advance Reasonable?

Courts look at a number of factors.  In a very competitive industry, where an employee leaves to work for a competitor taking clients along, courts have acknowledged that it is difficult to calculate the actual financial harm. On the other hand, a New York court refused to enforce a liquidated damages clause in an agreement that set it out as one of several alternate remedies, suggesting that the harm was therefore not sufficiently difficult to estimate. It is also important to keep in mind that the amount of damages has to be difficult to estimate at the time the contract is made, not at the time it is breached.  The evidence on this point is very anecdotal, but the argument might be difficult to make in the training situation outlined above where the cost of training was reasonably easy to determine.

How Much is Reasonable?

Courts will look at whether the sum set out in the agreement seems unconscionable or grossly disproportionate to the harm done.  This factor may also bear some relationship to the employee’s compensation.  Courts may look favorably on damage amounts that decline with the passage of the period of restriction.

Employers have a legitimate interest in a stable and loyal workforce. If employee turnover is a significant problem for your business, it would be good to know why.  Non-compete agreements with liquidated damages clauses may have a place in your retention strategy.  So may a scheme like Amazon’s offer of $5,000 to employees to get them to quit.  No single approach is appropriate in every situation.

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