Liquidated damages or a penalty clause?

Under the laws of England and Wales, parties have the freedom to contract and to negotiate their own terms. When a contractual term is not complied with (breached), the innocent party may have the right to a remedy which may include financial damages, specific performance and / or an injunction, such as when damages are not sufficient to remedy the breach and the innocent party requires that the other party is prevented from taking a certain action.

The law of contract allows for the innocent party to be put back to the position they were in prior to the breach occurring which is not intended to be punitive.

The lines are sometimes blurred because parties may enter into a contract which contains a ‘penalty clause’. However, some clauses may seem at first glance to penalise a party to the contract but could in fact be an agreed damages sum known as liquidated damages.  

What are liquidated damages?

Some contracts have a liquidated damages clause; this means that the parties agree to an amount to be paid if the contract isn’t fulfilled. Such clauses may be inserted into a contract to provide certainty as well as to quantify the risk should certain aspects of the contract be unable to be fulfilled.

As long as the clause is a reasonable estimate of the probable loss it is likely to be enforceable.

The difficulty arises when clauses are penal rather than a reasonable estimate. In other words, if the clause means a disadvantage to the contract breaker which is out of all proportion to the probable loss, the court is likely to view it as a penalty and therefore not enforceable and the court is likely to assess damages.

What is a penalty clause?

The rule against penalties operates when there is a breach of contract and upon breach a sum of money is paid or some other remedy is given by the party in breach to the innocent party, which effectively punishes the party in default to an extent disproportionate to the damage suffered by the innocent party. This could be money or some other property such as shares. 

The general rule is that a penalty clause will not be enforced beyond the actual loss of the innocent party.

An example of a penalty might be where a price is quoted for payment within a set number of days such as seven days and a higher price for later than the seven-day period. Another example might be when there is agreement for a payment when certain conditions are met.

The test for a penalty clause was established in the UK Supreme Court cases of Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] is:

"The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or some appropriate alternative to performance."

A clause is likely to be a penalty clause when:

• It comes into operation when there is a breach of contract. A court is unlikely to review contractual terms, but it will review damages for a breach of an obligation. 
• The clause cannot be justified – a genuine clause must seek to protect a legitimate interest of the innocent party.
• Even if a clause is designed to protect the legitimate interest of a party, it may still be deemed a penalty clause if it is extravagant.

The court will initially wish to determine legitimate interest, in other words, whether the party is genuinely trying to fix the breach. Factors such as commercial interests will be taken into account by the court in reaching its conclusion.

The court is also likely to consider if the clause is “extravagant or unconscionable” – there can’t be a legitimate interest if the effect of the clause is out of all proportion to the breach. For example, in the sister case Beavis v Parkingeye in 2015 the Supreme Court judges determined that an £85 parking charge, based on prices at that time, was neither extravagant nor unconscionable and as such was not itself a penalty clause.

Points to consider

In circumstances where there is a breach of contract, and some sort of proposed remedy is contained within the contract, it is sensible to consider if the proposed remedy is a penalty as if so, it may be unenforceable. Parties will need to consider what remedies may instead be available to them.