Liquidated Damages Clauses and Penalties in Commercial Contracts

It was decided in 1829 that in principle, that the parties to a contract may agree set or calculated sums that would be paid by a party in the event of a breach of contract. These liquidated damages clauses are therefore enforceable. The clauses are referred to as liquidated damages clauses due to the fact that a court is not required to quantify the losses sustained by a party.

In order to be enforceable however such liquidated damages clauses may not be penal in nature. In Dunlop Pneumatic Tyre Co Ltd v New Garage Co Ltd [1915] AC 79 (House of Lords) the court decided that a liquidated damages clause would be considered a penalty and unenforceable where the sum to be paid by the defendant was ‘extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be provided to have followed from the breach’.

In deciding whether a liquidated damages clause is a penalty or not, the court will take into consideration:

• whether the contract refers to the clause as a liquidated damages clause or a penalty;
• where the estimate of loss is imprecise, whether the sum is a genuine pre-estimate of the losses that would be sustained or whether it was disproportionate to the actual losses sustained;
• a stipulated sum is not disproportionate simply because it is notably greater than the actual loss sustained.
• whether such an imbalance of bargaining power existed between the parties at the time of the contract, that one party effectively dictated the terms of the contract.

Freedom of Contract and Extravagance

Generally, courts are reluctant to interfere with such clauses, as it is seen to be an interference with what the parties are otherwise quite to agree between themselves. An element of oppressiveness or extravagance in the stipulated sum will be decisive in deciding the question as to whether the sum is disproportionate. It is the likely damage in the ordinary course of events which is the subject of the pre-estimate, and not the conceivable damages that is the reference point for the calculation.

Methods of Calculation

There is no reason why the liquidated damages clause cannot be calculated with reference to a formula or time period, or where the actual damage cannot be pre-estimated with any certainty or is immeasurable at the formation of the contract.

The principle that penalty clauses are unenforceable apply equally to payments that a party to the contract would otherwise be entitled to withhold. That is to say, if a liquidated damages clause is in the form of a right to withhold payment, and meets the criterion of a penalty, the right to withhold the payment dissolves.

Where liquidated damages clause is characterised as a penalty, the claimant is entitled to sue for damages and have them quantified by a court, and the measure of damage will be the actual loss proved.

A simple form of liquidated damages clause is:

• "In the event that delivery of the goods are delayed, the supplier shall pay the customer the sum of £100.00 each day until the day of delivery to a maximum of £1,000.00."

For a synopsis on calculation of damages and their assessment click here, and more about late payment of commercial debts.