When two parties enter into a commercial contract, they do so with the best intentions. After all, neither party wants to spend time, energy and money involved in a dispute over the performance of the contract.
However, back in the real world, parties will continue to enter into agreements and subsequently fail to comply with their contractual obligations. In most cases, a breach of the contract will require the offending party to pay the innocent party damages for such breach. But how much will the innocent party be entitled to in damages?
Generally speaking, the guilty party will pay damages as required under common law. However, in order to avoid the difficulties that can arise in calculating how much this will be, and to provide a level of certainty, parties will often make provision in the contract for the level of damages to be awarded to the innocent party by including a liquidated damages clause. A liquidated damages clause also has the advantage, for the guilty party, of limiting its liability where the stipulated sum is less than the actual loss.
So if a contract includes a liquidated damages clause, that is the end of the problem right? Well, not quite.
One of the defences to a claim for liquidated damages is that the clause is unenforceable on the basis that it is a penalty. If a clause is considered by the Court to be a penalty, then it will not be enforced beyond the actual loss incurred by the innocent party. But under what circumstances is a liquidated damages clause deemed a penalty?
For over a century, the leading case on this particular question was Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 in which a liquidated damages clause was deemed to be a penalty if it is extravagant or unconscionable, with the predominant aim of deterring a party from breaching the contract, instead of compensating the innocent party by way of a genuine pre-estimate of loss. In Dunlop, Lord Dunedin referred to the following four tests to help determine whether a clause is extravagant or unconscionable:
- A clause may be penal if it is extravagant by comparison to the maximum possible loss arising from the breach.
- A clause may be penal if the breach of contractconsists only of not paying a sum of money, and the amount stipulated as damages is greater than the sum that ought to have been paid (if assessed at common law).
- A clause may be penal when a single lump sum is made payable by way of compensation, on the occurrence of one or more events, some of which may cause serious and others “trifling” damage.
- A clause is not a penalty merely because a precise pre-estimation of loss is impossible.
It remains the case that determining whether a liquidated damages clause is a penalty or not will depend on many factors, including the wording of the clause itself and the circumstances at the time of making the contract (rather than the time of the breach). The tests set out in Dunlop also remain relevant when considering straightforward liquidated damages clauses.
However, the Supreme Court, in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis  UKSC 67 stated that the real question is whether the clause is penal and not whether it is a genuine pre-estimate of loss. It held that in considering whether a provision in a contract is a penalty:
“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.”
As such, while the fact that the clause is not a genuine pre-estimate of loss may be relevant, it is necessary to consider other factors such as whether the innocent party has a commercial interest in the performance by the other party of its obligations under the contract. Similarly, even if the clause seeks to protect a legitimate interest of the innocent party, it may still be a penalty if it is extravagant or unconscionable.
So what can be deemed to be a legitimate interest of a party?
At its simplest, it may be the case that a party’s legitimate interest is to receive compensation for breach of a contract. However, there are more complex scenarios where compensation may not be the only legitimate interest. Whether a clause is justified will depend upon the facts of the case.
For instance, in Cavendish, the relevant clause in question was in a share purchase agreement which provided that, if the sellers carried out certain activities which competed with the interests of the relevant company, the buyers could withhold any outstanding deferred consideration payments and exercise a call option over the sellers’ remaining shares. The Supreme Court held that the buyers had a legitimate interest in the observance of the covenants which aimed to protect the goodwill of the business and the loyalty of the sellers was essential to preserve that goodwill.
In ParkingEye, the relevant clause imposed a charge for overstaying the free period of parking in a car park. The Supreme Court held that although the claimant had not suffered any direct financial loss from the defendant overstaying the period of free parking, it had a commercial interest in the observance of the terms of its contract with the defendant which extended beyond the recovery of any loss (i.e. the management of the efficient use of parking space and the generation of income to run the scheme).
In light of these cases, when drafting a liquidated damages clause, it is worth bearing in mind that not only should you ensure that the figure in the clause can be justified as a genuine pre-estimate of loss but also that it is commercially justified.
This article should not be taken as definitive legal advice on any of the subjects covered. If you do require legal advice, please contact Rosenblatt as above.