If a contract provides that upon default by one party, that party shall pay to the other a certain sum, and it appears that the payment is intended as a penalty and was inserted only for the purpose of securing performance, it will not be enforced by the courts. If, on the other hand, it appears that the sum is named as a measure of the compensation for a breach, it is called liquidated damages, and is valid, fixing the amount to be recovered if, by reason of a breach of contract, the provision comes into effect. Provisions of this nature are often introduced into building contracts.

The courts seek to ascertain the real intent of the parties in making the provision. But the fact that the sum is specifically called liquidated damages is not conclusive. If the sum named is clearly disproportionate to the damage which would be suffered, it tends to indicate that a penalty was intended. Again, where the contract involves doing many acts of various sorts, and only one fixed sum is named to be paid upon a breach, a similar inference would be drawn.

Conversely if the sum varies with the extent of the breach, as where a certain amount is to be paid for each day of delay, it is an indication of an intention to fix liquidated damages. If the damages in case of breach would be readily ascertainable, it is more likely that a named sum will be held to be a penalty than in cases where it be very difficult to determine the actual damage. The attempt to impose penalties being one to which the courts will not give effect, and the validity of such clauses depending largely upon their reasonableness, it is obvious that no general rule for drawing liquidated damage clauses can be given. The matter not being a simple one, it will be found that contractors often have very erroneous ideas on the subject, having learned of some one test sometimes applied by the courts, and believing such test to be conclusive. The necessity of care in drawing these clauses is increased by the fact that where there is doubt, the courts incline to treat the amount fixed in the contract as a penalty, rather than as liquidated damages. It is important to make the amount stipulated clearly reasonable as a measure of damages for the breach mentioned.