Article - Commercial Law

Liquidated Damages Clauses

Introduction

One of the important factors for any business is cash flow.  When drafting contracts, businesses will generally include a clause stating the amount payable on termination.  This allows the parties to know in advance the extent of their potential liability and to plan accordingly. Such clauses are called “Liquidated Damages Clauses”.  Recently, these clauses have come under criticism as being “penalty clauses” which has resulted in many consumers bringing claims against financial institutions for a return of the charges they have paid.

Are Liquidated Damages Clauses Enforceable?

If the clause is a genuine pre-estimate of the loss which is likely to be suffered by the innocent party as a result of a breach of contract, then it is enforceable.  The parties are, however, limited to that calculation even if the innocent party's loss is more than the amount claimed: Diestal v Stephenson [1906] 2 KB 345.  If, however, the amount claimed is not a genuine pre-estimate of loss then it is likely to be a penalty clause and unenforceable.

What is a Liquidated Damages Clause?

The Court will look at the intention of the parties at the time they entered into the contract.  It will consider whether the clause is a genuine attempt to assess the loss likely to be caused by the breach or whether it was designed to punish the party in breach.  The word genuine comes from the famous House of Lords case of Dunlop Pneumatic Tyre Company Limited v New Garage Motor Co Limited [1915] AC 79.

A different approach has, however, been adopted in Alfred McAlpine Projects Limited v Tilebox Limited [2005] EWHC 281 (TCC) where Jackson J substituted the work “reasonable” for “genuine”.  In Jackson J's view, there must be a “substantial discrepancy” between the sum claimed and the loss likely to be suffered before the Court will decide that the pre-estimate was unreasonable.  This is a distinct move by the Court and may lead to it only striking-down a clause where the losses claimed are unreasonable.

Factors the Court will Consider

The Court will consider whether the parties have described the clause as a liquidated damages clause or as a penalty clause: Elphimstone v Monkland Iron & Co (1886) 11 App Cas 332. Whilst this is a relevant factor, it is not conclusive.  The Court will consider as a question of construction whether it is a penalty or liquidated damages clause.

In Dunlop Lord Dunedin set-out the following principles when deciding whether a clause was a penalty:

  • Firstly, a clause will be a penalty if the sum claimed is extravagant or unconscionable in comparison with the greatest loss that could be proved to have resulted from that breach;

  • Secondly, a clause will be a penalty if the breach results in paying a sum of money which is greater than the amount which would have been paid had the defaulting party complied with its obligations;

  • Thirdly, there is a presumption that a clause will be a penalty when a single sum is payable on the occurrence of one or more breaches, some of which may be serious and others maybe trifling; and

  • Fourthly, if it is difficult to pre-estimate the loss or/and impossible then the clause is less likely to be a penalty.

The Use of the Penalty Clause Jurisdiction

The Court’s penalty clause jurisdiction is an exceptional one: the Courts are generally unwilling to conclude that a formula is oppressive particularly when it has been agreed by commercial parties.

Simply because a penalty clause jurisdiction is the exception rather than the rule does not mean it should be ignored.  A clause which takes into account the interest of one party only and fails to acknowledge the legitimate interests of another party may be struck down as a penalty: Cine Bes Filmcilik ve Yapimcilik v United International Pictures [2003] EWCA Civ 1669.

The Implications of a Clause being a Penalty

If a clause is not a genuine pre-estimate of loss or the amount claimed is unreasonable then it is likely to be struck down.  What, however, happens if it is struck-down?  Can the innocent party recover his actual loss which may be more that the sum claimed?  In Wall v Regeriaktiebogalet Lugguge [1915] 3 KB 66 the Court at first instance decided the innocent party could do so but this decision has been subject to academic criticism and is, therefore, unlikely to be followed.

Avoiding the Penalty Clause Rule

The Court can only apply the penalty clause rule in specific circumstances.  There are therefore three ways in which to avoid this rule.

The first way is to require payment immediately on entering into the contract but allow the other party to pay by instalments.  However, if there is a default then the balance becomes immediately due and payable. In this situation, the liability is simply accelerated.  For example, in a contract of hire the parties may state that the total amount payable is payable on the date of the agreement but the creditor will allow the debtor to pay by equal monthly instalments.  If, however, the debtor fails to pay any of the instalments on their due dates then whole balance will become immediately due payable.  This type of clause is not subject to the penalty clause rule: Protector Loan Company v Grice (1880) 5 QBD 592.

The second way is to say that the amount is payable on an event which is not a breach of contract.  The penalty clause rule only applies to liquidated damages payable on breach of a contract: Euro London Employments Limited v Claessems International Limited [2006] EWCA Civ 385.  For example, in Alder v Moore [1961] 2 QB 57 the defendant was a professional footballer.  He suffered a serious injury which meant he was unable to play professional football.  The insurers (the claimant) paid him £500 under his insurance policy.  The Defendant agreed with the insurer that:

In consideration of the above payment I hereby declare and agree that I will take no part as a playing member of any form of professional football and that in the event of infringement of this condition I will be subject to a penalty of £500.

The defendant later resumed his playing career and the insurers tried to recover the £500.  The defendant argued it was a penalty clause and therefore unenforceable.  The Court of Appeal decided that he had not promised to not play football again and the amount was therefore recoverable because there was no breach of contract.

The third way is to avoid specifying that a particular sum of money will be payable on breach of a contract.  If the parties make particular obligations conditions of the contract then if one party fails to perform that obligation, the innocent party can accept the breach as a repudiatory breach of contract: Lombard North Central plc v Butterworth [1987] QB 527.  The contract will then end and the innocent party will be entitled to damages.  The innocent party must, however, prove his loss in the usual way.

Conclusion

The penalty clause plays an important role in English contract law.  Modern interpretation suggests that the Court will consider whether the stipulated sum is reasonable and not whether it is a genuine pre-estimate loss.  However, for the time being, parties should try to estimate their likely loss in the event of a breach and ensure that it is only payable on a serious breach of condition.  If there is a blanket approach and the innocent party cannot justify the sum payable it is liable to be struck down as a penalty.  If, however, the innocent party has specified the particular breach is a condition of the contract then it will still be entitled to damages at common law which are recovered on the principles set out in Hadley v Baxendale (1854) 9 Exch 341.

Article First Published: 23 August 2007

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