Liquidated damages is a term use in the law of contracts to describe a contractual term which establishes damages to be paid to one party if the other party should breach the contract. Under the common law, a liquidated damages clause will not be enforced if the purpose of the term is solely to punish a breach of contract (in this case it is a penal clause). This is because such a clause does not allow the court to determine actual damages, and its enforcement would therefore require an equitable order of specific performance. However, courts sitting in equity will seek to achieve a fair result, and will not enforce a term that will lead to the unjust enrichment of the enforcing party.

In order for a liquidated damages clause to be upheld, two conditions must be met. First, the amount of the damages identified must roughly approximate the damages likely to fall upon the party seeking the benefit of the term. Second, the damages must be sufficiently uncertain at the time the contract is made that such a clause will likely save both parties the future difficulty of estimating damages.

For example, suppose Joey agrees to lease a storefront to Monica, from which Monica intends to sell jewelry. If Joey breaches the contract by refusing to lease the storefront at the appointed time, it will be difficult to determine what profits Monica will have lost, because the success of newly created small businesses is highly uncertain. This, therefore, would be an appropriate circumstance for Monica to insist upon a liquidated damages clause in case Joey does indeed fail to perform.