The amounts to be paid can be significant and it is therefore not surprising that their validity is often disputed by the paying party; one of the most common grounds for dispute is that the liquidated damages clause is not effective as it amounts to a ‘penalty’.
What are liquidated damages?
Liquidated damages are pre-agreed amounts of compensation which are to be paid to the ‘innocent’ party to a contract by the ‘contract-breaker’ on the occurrence of specified breaches of contract; liquidated damages are, for example, commonly payable when there is a delay in completing works by the agreed completion date.
The purpose of liquidated damages
Liquidated damages provide certainty and avoid a dispute regarding the amount to be deducted for the breach, as the right to be paid liquidated damages arises automatically upon the specified breach of contract occurs.
If liquidated damages are not agreed in advance then, in the event of a breach of contract, the usual remedy for the innocent party is payment of general damages i.e. an amount of compensation (to be determined by the Court) which is paid to the innocent party by the contract-breaker. In order to be successful in a claim for general damages, the innocent party must be able to prove its loss and that the breach of contract caused that loss. Court proceedings to determine the number of general damages which should be paid can, therefore, be expensive and time-consuming meaning that liquidated damages can often be a much simpler solution.
Caution: liquidated damages must not amount to a penalty
Care should be taken to ensure that liquidated damages do not amount to a penalty; a penalty is effectively a clause which punishes a party for its breach of contract. Liquidated damages should provide an alternative to the performance of the contractual obligation in question, rather than act as a punishment.
When do liquidated damages amount to a penalty?
It used to be the case that in order to avoid being a penalty, liquidated damages had to be a ‘genuine pre-estimate of loss’ which would be suffered by the innocent party in the event of the specified breach of contract occurring. The Supreme Court did, however, clarify the law in this area in 2015 when considering the cases of Cavendish Square Holding v El Makdessi; ParkingEye v Beavis. In its judgment, the Supreme Court stated that:
- the “true test” to determine whether a clause amounts to a penalty is whether “it is a secondary obligation (e.g. a liquidated damages clause) 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.”; (emphasis added)
- the innocent party’s interest is in performance or some appropriate alternative to performance; not simply in punishing the contract-breaker;
- compensation alone may not necessarily be the only legitimate interest that the innocent party may have in the performance of the contractor breaker’s primary obligations; and
- in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption would be that the parties themselves are the best judges of what is legitimate in a clause dealing with consequences of a breach.
As a result of the Supreme Court’s decision in Cavendish Square Holding v El Makdessi; ParkingEye v Beavis, the fact that a liquidated damages clause may require the contract-breaker to pay more than what would have been a ‘genuine pre-estimate of loss’ does not necessarily mean that it will be construed as a penalty.
The wider interests of the innocent party in the performance of the contract breaker’s primary contractual obligations will also be considered (i.e. so as to establish whether there is commercial justification for enforcing the clause). The commercial bargaining power of the parties at the time the contract was formed will also be taken into account; it seems unlikely that a Court would refuse to enforce a liquidated damages clause in a contract which was negotiated between legally represented parties of equal bargaining power.
Our top tip: liquidated damages benefit both employers and contractors
Many contractors object to liquidated damages clauses as they cannot see past the principal that it involves them making payment of sums to the employer. However, liquidated damages clauses can be a positive step for a contractor as they act as a limit on the contractor’s liability in the event of the specified default occurring.
By agreeing to a liquidated damages clause contractors know the extent of their liability in the event of the specified default occurring. A well-negotiated liquidated damages figure could result in the contractor saving money when compared to general damages which may be awarded by a court, including the legal costs that the contractor will have needed to spend resolving the dispute.
Many of our clients are now using liquidated damages clauses to their advantage, for example, when trying to stress the importance of meeting completion deadlines to employees and/or subcontractors as there is a figure in black and white for everyone to see the effect on the contractor of the project being delivered late.