Terms of Contract and Penalty Clauses in English Law

Penalty clauses are terms of contracts that seek to impose upon a party to the contract the obligation to pay a sum of money in the event that the contract has been breached, and the terms of the contract cannot be properly classified as a liquidated damages clause. Sums specified as being payable under penalty clauses are not recoverable, as opposed to liquidated damages, which are.

Penalties and Liquidated Damages

The commercial purpose of such clauses is to relieve the party not in breach of having to prove their damage: the contract specifies the sum payable and in practice reduces the instances of money claims proceeding to court to be litigated. Liquidated damages clauses must be a genuine pre-estimate of the loss to be suffered by the party in the event of a breach. The failure to do so runs the risk of the clause being classified as a penalty clause. Whether the term is a penalty clause or not is determined as at the time the contract was formed and not at the time the contract was breached.

Tests

Simply because a clause is stated to be a penalty clause is not determinative that it is so. Penalty clauses are oppressive in nature, and serve the purpose of deterring the party labouring under the threat of their imposition from breaching the contract. Several tests have been developed to cater for the various forms that contractual penalties may take, and the factors that may be taken into account may include:

1. whether the sum payable is extravagant when compared to the greatest loss that would be suffered by the innocent party

2. the sum payable is greater than the sum that ought to have been paid

3. when a single lump sum is payable, for any number of breaches of contract and those breaches include both serious and trivial damage. To avoid a term of a contract being determined to be a liquidated damages clause, one size does not fit all.

The measure of the calculation should reflect the claimant’s net loss. Sums otherwise payable under a contract for performance are not penalty clauses as there is no increase in the sums payable under the contract (although the consequences may be oppressive) and sums payable in circumstances that are not connected to a breach are also not properly characterised as liquidated damages or penalty clauses.

Making the Calculation

As a matter of public policy, terms of contracts cannot be used for parties to profit from the breach of a contract by a person. Where the claimant has made a genuine effort to determine their loss and has acted in good faith, the clause will not be classified as a liquidated damages clause regardless of how unreasonable it may appear to others.