Penalty clause vs liquidated damages

In high value and/or high important contracts it is tempting to want to protect your interests by including a clause stating that certain breaches will lead to an agreed very high penalty payment. Such clauses are known as liquidated damages and/or penalty clauses.

English law is based on proving loss and only rarely awards compensatory or penalty damages. Historically, this has meant that even where parties to a contract agree a liquidated damages or penalty clause, this would not be enforceable.

The law has recently changed and liquidated damages clauses may now be enforceable but must be very carefully drafted.

In this insight, we

• Address the common pitfalls relating to penalty clauses.
• Outline the commercial factors that a court may consider.
• Consider what needs to be done to ensure that the terms of your commercial contract are enforceable in the event of a commercial dispute.

What is a Liquidated Damages clause?

A liquidated damages clause is a genuine pre-agreed amount that is paid following a specified breach of contract.

What is a penalty clause?

A penalty clause is a clause that does not represent a genuine estimate of the loss following a breach of the commercial contract and is typically much higher than the likely loss. Hence the amount specified by the penalty clause is not related to the actual loss.

Is a liquidated damages clause safer than a penalty clause?

On the face of it, probably yes, if the liquidated damages amount is reasonable and does not appear to be an excessive penalty amount.

A damages clause can of course be both a liquidated damages clause and a penalty clause if the amount is fixed and clearly an amount intended to have a significant penalty element

Can a penalty clause be lawful and enforceable?

In theory, under the latest law, it can be. Whether it will be depends on the legal test which test considers whether the contractual remedy for breach is out of all proportion to the innocent party’s legitimate interest in enforcing the counterparty’s obligations under the contract.

There are other complications which the court will also consider including whether the penalty applies against breaches of “primary obligations”, which would be ok, or “secondary obligations” which would not.

The courts will not be fooled by labels, but clauses can be saved through careful drafting.

How to draft a liquidated damages clause

The main problem with a liquidated damages clause is, if it is deemed to constitute a threat to ensure performance of the contract rather than being aimed at compensating the injured party (with the amount payable being “extravagant or unconscionable” going well beyond any loss that would be suffered) it will constitute an unenforceable penalty clause. If so, then the party in breach can avoid payment.

The  approach of the courts means , before drafting a liquidated damages clause, businesses should :-

• Explain liquidated damages amount – a contract should explain the liquidated damages amount in full detail. This includes a description of how the parties calculate the figure, a schedule describing the factors that make up the amount, and detailed justification of the figures.
• Keep records – it is an idea to keep a note of 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 rely on labels – 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”. The courts will instead look to the substance of the agreement, and the circumstances in which the particular clause is triggered. We draft for you to reduce risks.
• Contracts should be carefully drafted – boilerplate templates look attractive but when you come to rely on them you are likely to find they do not work.