Penalty clause vs liquidated damages

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The Supreme Court recently considered the law on penalty clauses. The previous law was that penalty clauses were not enforceable under any circumstance. However, the position on penalty clauses has now been relaxed. It remains the case that liquidated damages clauses can be enforced, if the contract explains the calculation.

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 penalty clause?

A penalty clause is a clause that 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.

The drafting of a commercial contract – rationale

Traditionally, under English law, a penalty clause was unenforceable. However in the decisions in the cases of Cavendish Square Holding BV v Talal El Makdessi (“Makdessi”) and ParkingEye Limited v Beavis (“ParkingEye”), the Supreme Court put forward a new test for penalty clauses. This test focuses on the legitimate interests of the parties and is significantly more flexible than the previously rigidly followed test. The 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.

The penalty rule applies against breaches of “primary obligations”. Therefore the main objective for drafting purposes will be framing a penalty clause as a primary obligation rather than a secondary one. The courts will not be fooled by labels.

The Supreme Court has now made it clear that “in a negotiated contract between properly advised parties of comparable bargaining power, the initial presumption should be that the parties are the best judges of what is legitimate in a provision dealing with the consequences of a breach”. This will impact more on larger commercial businesses that negotiate their contract.

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. 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?

Liquidated damages clauses deal with the possibility of breaches of a contract. The sum of loss is pre-determined and written into the contract. The main purpose of the clause is to enable an injured party to a contract to get compensation for loss suffered.

Benefits of liquidated damages clauses

The main benefit of including a liquidated damages clause is that it can allow the injured party to get compensation of the specified amount once the breach has occurred.  This can have cost advantages as parties to not need to go through the process of bringing a claim under the common law for damages.

Example of an acceptable liquidated damages clause

Azimut-Benetti Spa v Healey is a recent case where a liquidated damages clause was upheld.

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 considered multiple factors and 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

A contract should explain the liquidated damages amount in full detail. This includes an:

  • 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”. 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.