Penalty clause vs liquidated damages
- Helen Curtis
- Updated: Fri, 9th Dec 2016
Penalty clauses are not enforceable. Liquidated damages clauses can be enforced, if the contract explains the calculation. In addition, Courts are now more willing to consider commercial factors.
In this insight, we
- Address the common pitfalls if legal advice is not sought.
- Outline the commercial factors that a court may consider.
- Tell you what needs to be done to ensure that the terms of your commercial contract are enforceable in the event of a commercial dispute.
The drafting of a commercial contract – rationale
Traditionally, under English law, a penalty clause is unenforceable. An alternative is an agreed liquidated damages clause. A liquidated damages clause is a pre-agreed amount that is paid following a specified breach of contract. However, liquidated damages clauses are not straightforward or even definitely enforceable. We advise on the grey areas.
When will a liquidated damages clause be enforceable?
A penalty clause does not represent a genuine, reflective estimate of the loss following a breach of the commercial contract. Hence the amount specified by the “penalty clause” is not related to the actual loss. If it is a penalty, then the injured party cannot enforce it against the party in breach.
However, an acceptable alternative is a provision for liquidated damages. This clause is a genuine pre-estimate of any loss resulting from the breach.
The complexity of a commercial contract
Nevertheless, the commercial complexity of contractual provisions is increasing. A strict application of the definition of penalty clauses leads to the courts dismissing commercially justified clauses as penalty clauses. That is why experienced drafting is required. Without it, the inevitable pitfall is there – the clause is unenforceable.
However, recent case law reflects the courts taking a more commercial and flexible stance as to whether or not a clause is a penalty clause.
Azimut-Benetti Spa v Healey
A recent case was Azimut-Benetti Spa v Healey. The court considered multiple factors to determine if a clause was a penalty or a liquidated damages clause.
In this case, a builder of luxury yachts had agreed to sell a yacht. Payment was in instalments. The parties agreed that if the buyer terminated, the seller was entitled to 20% of the total price, as compensation for their loss.
The buyer failed to pay the first instalment. The seller terminated and claimed 20% of the total price, as per the agreement. The buyer argued the 20% was a penalty clause, because the amount was not relative or reasonably foreseeable.
The courts decided the clause was commercially acceptable, and it was not a penalty clause.
How to draft a liquidated damages clause
The case demonstrates the courts increasing willingness to consider commercial issues. The new approach means:
Explain liquidated damages amount
Explain the liquidated damages amount in full detail. This includes an:
- Explanation of how the parties calculate the figure;
- A schedule describing the factors that make up the amount, and
- Detailed justification of the figures.
Note any discussions about the liquidated damages clause. Such notes are useful for when a dispute emerges. If you can show the other party fully understood the nature of the clause, it’s more likely the courts will enforce the clause.
Don’t just name a “liquidated damage” clause
Courts don’t simply look at the words in the contract. Naming a clause “liquidated damages clause” does not mean the courts will decide it is a “liquidated damages clause”, if it has the characteristics of a penalty clause. We draft for you to reduce risks.
Helen Curtis is a partner in the commercial team. If you want to ensure that the entirety of your commercial contract is enforceable, then you will need specific legal advice. The drafting of the commercial contract then follows the advice.
Contact Alex for advice on this issue - whether you are concerned about a clause which has been drafted for a contract or whether you are involved in a contractual dispute and there is an issue over whether a clause may be considered a penalty clause and whether it may be enforceable or not.