Liquidated Damages

This guide explains the critical steps to take in making sure liquidated damages clauses are enforceable.

Liquidated damages clause

Including a liquidated damages (LD) clause in a commercial contract is a popular way of dealing with the possibility of breach. The essence of an LD clause is that a party in breach of its obligations under a contract is obliged, by that contract, to pay a particular sum by way of compensation for that breach. The sum is fixed in advance and written into the contract.

The courts recognise the advantages of these clauses for both parties. These, combined with the general principle of freedom of contract, have led to a general view on the courts' part that these clauses should be upheld, especially in a commercial context where the parties are seen as free to apportion the risks between them. However, an LD clause which constitutes a penalty will not be enforceable. A number of pointers have emerged from the case law on the topic which must be taken into account when considering this issue. There are also a number of drafting points to follow which will help any such clause to be upheld.

LD clauses: a practical remedy with numerous advantages

LD clauses have much to recommend them in the commercial context. The most important element of such a clause is that the sum specified is payable once the breach occurs without the need to wait for the loss to crystallise. The injured party is spared the time and expense of a common law action for damages for breach of contract. Neither is it under any obligation to mitigate as it would be in an ordinary claim.

Remoteness of damage can also be an issue in a contractual damages claim. However, where the non-breaching party can rely on an LD clause, questions of remoteness do not arise. This in turn means that potential problems of under-compensation for the injured party may well be avoided, especially in situations where significant consequential or idiosyncratic losses result from the breach. Further, knowing in advance their potential exposure on a breach brings an extra degree of certainty to the parties and also, perhaps, to their insurers. Sensible LD provisions (for example the service credit regime built into many outsourcing contracts) can be a practical and workable method of dealing with minor breaches throughout a long-term contract; one advantage of this is that the parties often find it possible to continue their commercial relationship going forward despite an element of past poor performance.

Identifying a genuine LD clause

As mentioned above, the essence of a liquidated damages clause is that the sum which the breaching party must pay on a breach is fixed in advance and written into the contract. Distinguish the following:

• Indemnities: Commercial contracts often provide for the breaching party to indemnify the non-breaching party in respect of any loss it suffers as a result of the breach. However, unlike a true liquidated damages clause, the sum payable is not known until the breach has occurred and the loss has crystallised.
• Clauses where the sum payable in respect of the breach is fixed by a third party: Again, these are not true LD clauses because the sum is determined by an external factor, and after the breach, rather than being specified in the contract.
• Incentive payments: Some contracts provide for the contract sum to increase if the supplier meets certain milestones ahead of time. Although this is often a very effective way of securing performance, the payment increase is not triggered by breach and such a clause therefore operates in the opposite way to a genuine LD clause.

Typical uses of LD clauses

Situations in which LDs often appear include:

• Construction contracts: These typically provide that, if completion is delayed by reason of the contractor's breach, the contractor will be liable to pay the employer a specified sum for each day, week or month during which the delay continues.
• IT development contracts: The mechanism works in a similar way to that described above with payments triggered by delays in completion.
• Outsourcing contracts: In this context, LDs often take the form of service credits which apply to reduce the sums payable if services are not performed to the required standard.
• Employment contracts: Two examples of LD clauses in employment contracts have come before the courts in recent years¹. In one, it is worth noting that the judge commented that, although it was unusual to find them in this type of contract, there is no reason why they should not be used. 

The penalty trap and the risk of unenforceability

The considerable advantages of LD clauses will be lost if the clause is not legally enforceable. The courts recognise that the benefits of LD clauses, supported by the underlying theory of freedom of contract, strongly point to such clauses being upheld. This is particularly so in a commercial context. However, they are not foolproof. Ultimately, a clause which operates this way can be either an LD clause, in which case it will be enforceable, or a penalty, in which case, as a matter of public policy, it will not. The courts have examined the penalty issue on many occasions in the context of LD clauses and it came under the spotlight of the Supreme Court in 2015 in the case of Cavendish Square Holdings BV v Talal El Makdessi. Here, it was acknowledged that although the doctrine of penalties is an "ancient, haphazardly constructed edifice which has not weathered well", it still plays a useful role in regulating commercial contracts. The key steps are knowing when the rule applies and, secondly, what constitutes a "penalty".²

When does the penalty rule apply?

The purpose of the rule is to prevent a claimant in a breach of contract situation from claiming any sum of money or other remedy which bears little or no relation to the loss actually suffered. It examines the fairness of the remedy and not the fairness of the deal as a whole. In other words, it applies to the secondary obligations in a contract (i.e., those which come into play when the primary obligations are breached) and not the primary obligations themselves. See paragraph 7 below for examples.

What makes a contractual provision penal?

The courts have traditionally applied four tests³ to decide this question. These are:

• A provision will be penal if the sum provided for is "extravagant and unconscionable" in comparison to the greatest loss that could conceivably be shown to result from the breach.
• A provision will be penal if the breach consists solely of the non-payment of money and it stipulates a larger sum.
• A clause will be presumed to be penal if the same sum is payable for a number of breaches of varying degrees of seriousness.
• A clause will not be treated as penal solely because it is impossible to estimate in advance the true loss likely to be suffered.

In the Supreme Court's view, these four tests have, over time, been given more weight than was originally intended, which has led to artificial distinctions creeping in to the penalty doctrine. The recent shift towards looking at the "commercial justification" of clauses was an attempt to steer judicial thinking back to the fundamental principles behind the penalty rule but was misguided. Focusing on the true purpose of the clause - i.e., to deter a breach or to compensate for loss - is not helpful either. While these four tests remain helpful guidance, the true test is whether the remedy is disproportionate to the legitimate interest it was designed to protect.

The reformulated test. In practice, this will involve a value judgement by the court and the first step in this process is identifying the legitimate interest which the clause in question is designed to protect. The next step is to look at the remedy. If that clause is a secondary obligation which imposes a detriment on the breaching party which is out of all proportion to the non-breaching party's interest in enforcing the primary obligation, then it will be unenforceable as a penalty. This is likely to be reasonably straightforward for simple liquidated damages clauses. For other, more complex situations, the principle remains the same - the court should ask whether the remedy is "exorbitant or unconscionable".

LD clauses in a subcontracting situation; unenforceable LDs cannot act as cap

The decision in Steria Ltd v Sigma Wireless Communications Ltd⁴ is a useful illustration of how LDs work in practice in a subcontracting situation. The background involved a contract for the provision of a new computerised system for fire and ambulance services. Sigma, the main contractor, sub-contracted part of the work to Steria on terms which provided for Steria to complete its tasks in four main sections with LDs payable if a delay occurred in any of those sections. Under the sub-contract, 0.25 per cent of the value of each task was deductible for each week during which completion of that task was delayed. The total LD sum was capped at10 per cent of the contract price. The main contract had a similar cap on the total but LDs were fixed at 1 per cent of the contract value for each full or partial week that overall completion was delayed. Delays occurred; Sigma claimed LDs and, in the alternative, general damages from Steria.

One of Steria's arguments centred on whether the LDs were penal in nature. Steria argued that the structure of the contract, with LDs payable in respect of each section, could operate as a penalty if the final completion date was ultimately met irrespective of delays having occurred in completing any one of the first three tasks. Because achieving completion of the sub-contract on time did not translate into a delay under the main contract, Sigma would not be liable to its customer, although Steria would be liable for LDs under the sub-contract. The judge did not accept this. Delays in tasks 1-3 may well have caused Sigma loss even if the final completion date could be met. Sigma, or other sub-contractors, could conceivably suffer delays and disruption, thus incurring losses or expenses which could not be recovered elsewhere. It was also relevant that both contracts capped the total recoverable LDs at 10 per cent. The clause was not penal. Neither did the judge think that a general damages claim was a possibility, because the contract clearly stated that Sigma's sole remedy was LDs. He did, however, offer the view that if the LD clause had been unenforceable as a penalty it could not in any way act as a cap.

Limiting the scope of the penalty rule: sum in question must be payable as a result of breach

The rule against penalties is not applicable to many payments made under a contract. Three cases provide some guidance on the point. One very helpful test is whether the sum is payable as a primary obligation or whether it is payable as a secondary obligation, i.e., on breach of a primary obligation. If the former, it will not be a penalty. This suggests that, wherever possible, the relevant clause should be drafted as a primary obligation rather than as a remedy for a breach. The point arose in Makdessi in relation to two clauses, the first of which withheld the payment of two final instalments of the purchase price, and the second of which provided for the transfer of shares at a reduced price, if various restrictive covenants were breached. The Supreme Court, after some debate (and in the case of the transfer of shares not unanimously), held that these clauses constituted primary obligations as they amounted to a price adjustment mechanism closely tied in to the overall commercial objective of the deal. In Associated British Ports v Ferryways NV⁵ the parties entered into an agreement for handling cargo containers at a port. The agreement contained a minimum throughput obligation which provided that, if the number of Units (as defined) fell below a certain number in each year, the customer would nevertheless be obliged to pay a fixed fee. The customer subsequently argued that this was a penalty. The judge, however, noted that, on the correct construction, the aim of the clause was to provide the supplier with an annual revenue stream and not to threaten the customer into performing. The obligation was not a secondary one, triggered by a breach, but was instead a primary obligation given in exchange for a promise by the supplier "…and as such cannot be a penalty".

A similar issue was raised in M&J Polymers Limited v Imerys Minerals Limited. This involved a "take or pay" clause in an agreement for the supply of dispersants. The buyer was obliged to pay for minimum quantities of the materials even if it had not ordered them. One of several points which the court had to decide was whether this clause constituted a penalty. Counsel could find no direct authority on this, so the judge was obliged to decide it de novo. He commented that the clause was "not the ordinary candidate for such rule", but the law on penalties could potentially apply. Following Makdessi however, the general view is that take or pay clauses are likely to be analysed as primary obligations, therefore falling outside the scope of the rule on penalties.

The need for a link between breach and remedy was highlighted in Edgeworth Capital (Luxembourg) Sarl v Ramblas Investments BV.⁶ Here the court held that payment of a fee which was merely accelerated in the event of a default, but which would have been payable anyway, was not subject to the penalty rule.

Commercial background and type of contract is significant

As always, when applying the penalty rule, the court will look at the substance of the clause in question rather than its form or how it is labelled by the parties. The overall fairness of the deal will not be relevant. However, in Makdessi, the Supreme Court pointed out that context can sometimes be relevant and, in particular, 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".

Comment: These decisions show the flexibility of LD clauses as a potential remedy in many commercial contexts. Although the rule against penalties remains the biggest risk to the enforceability of these clauses, lawyers can be reassured by the courts' continuing reluctance to intervene in contractual relationships between experienced commercial parties unless absolutely necessary. The focus on "legitimate interest" is worth bearing in mind, however, and it may be sensible to identify this in the contract itself. In fact, in Makdessi, the contract expressly recognised that the restrictive covenants in question had been included specifically to protect the extremely valuable goodwill in the business being sold. It is also worth noting the courts' increasing awareness of the commercial background and justification underlying LD clauses and the context in which they were agreed and it may be sensible for parties to keep written notes of the background and reasons for choosing the sums they did.

1. Tullett Prebon Group Ltd v El-Hajjali [2008] EWHC 1924 (QB); [2008], IRLR 760 and Murray v Leisureplay Ltd [2005] EWCA Civ 963; [2005] IRLR 946.
2. [2015] UKSC 67.
3. Originally formulated in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79.
4. [2007] EWHC 3454 (TCC).
5. 2 Lloyd's LR 2008 355.
6. [2015] EWHC 150 (Comm).