A liquidated damages clause is a provision which represents an agreement between parties as to the payment that should be made if a particular contractual term is breached.
Where a liquidated damages clause is included in a contract, it is specific to an obligation which is known as the primary obligation, with the payment clause being activated if that primary obligation is breached.
Examples could include where a construction contractor fails to complete a build by the completion date, or where a service provider fails to meet the specific standards outlined in the contract causing loss.
The advantage to contract parties of setting out the level of damages to be paid in advance is primarily in relation to cost and time. In effect, you avoid having to go through the process of bringing a claim for damages under the common law, which can be a lengthy, uncertain and costly process particularly if the case ends up in court. By avoiding litigation you also avoid straining the commercial relationship. It is possible that once the liquidated damages have been paid, the contract can continue to its conclusion. Over and above this suppliers of services often favour the inclusion of a liquidated damages clause as they know the consequences of failing to comply with an obligation from the outset. Should they be unable to meet the terms of their obligation they won’t be faced with escalating costs and fees as their liability is effectively capped.
When drafted correctly liquidated damages can be incredibly timesaving and useful. However, they must be considered carefully by both sides, and set-out properly and precisely. If not there is a risk that they will be read as a ‘penalty clause’ and will be unenforceable under English law.
Are liquidated damages clauses enforceable?
The short answer is yes, but within specific parameters. If a liquidated damages clause is drafted in a way that is penal, the law will not recognise it as enforceable. Penal can be defined as where the detriment (the damages in the case of a liquidated damages clause) is disproportionate in comparison with the legitimate interests of the party that is not in breach. If the detriment is excessive, then a court will determine that the liquidated damages provision is a penalty clause.
So how do you stop the measure you inserted into your contract to provide you with some protection from litigation costs following a breach, becoming the focus of its own litigation?
The traditional approach
Until 2015, the accepted position on what made a penalty clause was outlined in a case dating back to 1915 (Dunlop). In distinguishing between an enforceable liquidated damages clause, and a penalty clause, the case of Dunlop outlined four tests. The focus of these tests was a consideration of whether the purpose of the provision was to prevent a party from contravening the terms of the contract or to provide a genuine pre-estimate of loss.
Importantly the court in Dunlop emphasised the need to look beyond what the provision was called, and focus on the substance and effect of it, along with the surrounding facts and circumstances at the time of entering into the contract. However, factors that may indicate that a clause was a penalty clause included:
• If the sum was extravagant and unconscionable set against the biggest loss that could have been foreseen at the time of agreeing to the contract.
• Where the contract was for the payment of money and the sum due following non-payment was more than the total amount.
• Where one clause covered multiple types of breaches with no regard for differentials in the loss.
• Difficulty in assessing loss at the time of contracting did not make the clause penal.
For 100 years this was the approach taken by the courts and lawyers as representing the best way to distinguish between a legitimate liquidated damages clause and one that was a penalty clause in disguise. The test has since been reconsidered but where a party’s interests are purely financial and quantifiable, the new test provides the same practical outcome and echoes the Dunlop approach.
The new approach
However, since 2015 and the Supreme Court ruling in the cases of Cavendish and Beavis, the court has taken a broader view of what penalty means.
The four-stage test was considered to focus on too narrow a set of rules when contemplating what constitutes extravagant or unconscionable. The focus is now on whether the party not in breach has a legitimate interest to enforce it.
Legitimate interest is still judged as at the time that you enter into the contract but allows for consideration of more than just money. For instance, in relation to a liquidated damages clause if the sum agreed does not reflect a pre-estimate of loss, that does not, in itself, mean it will be unenforceable. The party who is not in breach may have a legitimate interest beyond that of compensation.
To illustrate, in the Cavendish case the clause that was contravened related to the purchase price, which was payable in instalments, and was core to the contract. Cavendish had agreed to buy a controlling stake in a company, but only once the seller had agreed not to compete with the company. If he did, he would forfeit the right to the last two payments and could be forced to sell his remaining shares to Cavendish at a reduced price that reflected no element of goodwill. On the face of it, the clause may be considered to penalise the seller, excluding him from something that he would otherwise be entitled to and not accurately reflecting the loss of the purchaser, Cavendish. However, as Cavendish had a legitimate commercial interest in protecting the goodwill of the company by including the condition, the court held that the sum was not extravagant or unconscionable in those circumstances.
Where a party’s interests are purely financial and quantifiable, the test in practice, may not be too far removed from the Dunlop approach. In that circumstance, it is likely that if the sum is wholly disproportionate to the loss, then a liquidated damages clause will be held to be unenforceable. But where a party’s interest goes beyond financial the court will have to consider whether those interests are legitimate and whether the sum is extravagant when set against them.
When should you consult a lawyer?
Arguably all this new approach has done is significantly increased the uncertainty surrounding the enforceability of a liquidated damages clause. If the provision is disputed, it serves to make the courts task more difficult which could, in turn, contribute to increased expense and duration of any court proceedings.
This makes it all the more imperative that when you are entering into a negotiated commercial contract that you consult a lawyer at the outset. It is not enough to label a clause a liquidated damages clause, it must be drafted with precision following upon a consideration of the interests you are trying to protect and the level of protection you want to afford them. If both parties are represented at the time of negotiations and fully disclose the purpose of any clause, then it is more likely a court will adjudge that the contracting parties have considered what a proportionate response to the breach is. The clause then has a much greater chance of being enforced and achieving the aim of certainty, reducing the impact of one party’s breach on the other.
Negotiating a commercial contract
Often when you enter into a commercial contract, its success or failure impacts far more than the subject matter central to the contract itself. Specifically, its failure could cause damage to you, or your company’s, reputation affecting the value of goodwill. Whatever the consequences of a party’s breach sometimes the loss may be difficult to ascertain and cost thousands in legal costs to settle. As a contracting party, this is something that you will want to avoid. And it’s something that requires consideration not at the point that a breach happens, but at the point that you are writing the terms of your contract. A good lawyer will be able to take you through various scenarios and help draft a contract that contains clauses that will help minimise the ramifications of a breach.