11 December 2015 by

Distinguishing between liquidated damages and penalties

When negotiating commercial terms, it is common for companies to agree that, if a contract is breached, a specified amount of damages will be paid to the innocent party.  This type of clause is called a liquidated damages clause.

Historically, the general rule was that the specified sum had to be a genuine pre-estimate of the loss that would be caused by the breach.  If the specified sum was not a genuine pre-estimate of that loss, the risk was that the clause could be determined to be an unenforceable ‘penalty’ clause.

However, in two recent cases, Lord Neuberger and Lord Sumption described the penalty rule as ‘an ancient, haphazardly constructed edifice which has not weathered well’.

As such, the judges moved away from the ‘genuine pre-estimate of loss’ approach, when clarifying the rule on penalties, and said: “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 in some appropriate alternative to performance.”

The judges were keen not to set a precedent which could lead to “interference with freedom of contract” and stated that the Court should not strive to identify a clause as penal and should recognise that “In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.”

Should you wish to discuss the enforceability of any liquidated damages clauses in any of your contracts, please contact Tom Lawrence on 020 7288 4769 or tomlawrence@boltburdon.co.uk.

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