Penalty clauses and liquidated damages: Traps for the unwary

Penalty clauses and liquidated damages: Traps for the unwary

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Author: Rob Cruise

Liquidated damages (LDs) clauses stipulate that a certain specified sum of money will be payable by one ('guilty') party to the other ('innocent') party, where there has been a particular breach of contract.

What are Penalties and Liquidated Damages?

LDs are a useful contracting tool in commercial agreements, but there is a danger that, if they are not considered properly or drafted correctly, they may be construed as a 'penalty clause', and therefore unenforceable under English law.

The recent judgment in E-Nik Ltd v Department for Communities and Local Government has reignited the debate about 'take or pay' clauses by confirming that such provisions could also fall foul of the rule against penalties.

What is all the fuss about LDs?

LDs are often payable where there is a delay in delivery or completion of a particular service, or where a service fails to meet certain specified targets.

LDs bring a greater degree of certainty than relying on the contract law rules regarding claiming general damages - you know how much you can recover (or how much you will pay) if a certain type of breach occurs.

LDs are also often better for preserving the commercial relationship - the guilty party pays the LD, then the parties get on with performing the rest of the contract, rather than embarking on a more protracted damages claim. Suppliers often like to include LDs because, if drafted correctly, they can act as a cap on the supplier's liability.

What is the problem with LDs?

As set out in the key judgment in this area - Dunlop Pneumatic Tyre Co. Ltd. v New Garage & Motor Co. Ltd. (1915) - in order for an LD cause to be enforceable (rather than being a penalty), the sum payable upon breach must be a genuine pre-estimate of the loss the innocent party would suffer in respect of that breach. If the intention of the LD is to threaten the guilty party into performance (rather than to compensate the innocent party), it is likely to be seen as a penalty.

Take or pay?

A take or pay clause requires the buyer to pay for a minimum quantity of goods or services, whether the buyer actually takes the goods/services or not.

In E-Nik Ltd v Department for Communities and Local Government (2012), Burton J of the High Court (citing his own judgment in a 2008 case) confirmed that a take or pay clause could in principle be construed as an unenforceable penalty. On the facts, the clause in question, which required the client to take a minimum of 500 consultancy days, was commercially justifiable, did not amount to oppression and was negotiated freely - so was not a penalty.

Take or pay clauses have generally been seen to give rise to a debt rather than a damages claim for breach of contract, and for this reason it was commonly believed that the rule against penalties (which applies to specified sums payable upon a breach of contract) would not apply.

Burton J stated in the E-Nik judgment that the client's failure to take the minimum number of days gave rise to a debt rather than a damages claim, but he did not elaborate on why the rule against penalties could still be applied. It remains to be seen whether the courts will clarify this point in future and whether take or pay clauses will continue to be subject to the rule against penalties.

Is it justified?

Recently, the courts have shown a consistent reluctance to interfere with commercial contracts signed by parties of broadly similar bargaining power.

The difficulty of arguing that a clause is a penalty was highlighted by the case of Azimut-Benetti SpA (Benetti Division) v Darrell Marcus Healey (2010), where the High Court found that a clause entitling a luxury yacht-builder to retain 20% of the purchase price of the yacht upon termination for late payment, was 'commercially justifiable' in the circumstances and therefore not a penalty.

In Cavendish Square Holdings BV and another company v Makdessi (2012), the buyer purchased 60% of the holdings in the world's largest advertising and marketing communications group, and had an option to buy the remaining shares.

Payment for the shares would be in three instalments, and if the seller breached certain restrictive covenants this would cancel any outstanding instalments and trigger the option for the buyer to purchase the remaining shares at a discounted price (to reflect the impact of the breach on the valuable goodwill of the target company).

The seller breached the restrictive covenants, but argued that the buyer's right to cancel the outstanding instalments and buy the remaining shares at a discounted rate amounted to a penalty.

However, the High Court found that although the rule against penalties could apply under such circumstances, the terms were not penal for these key reasons:

  • there was a commercial justification for the terms
  • they were not extravagant or oppressive
  • the main purpose of the terms was to provide a clean break to the commercial relationship and to adjust consideration for the remaining shares to reflect the loss in goodwill caused by the breach
  • the terms were negotiated heavily by experienced solicitors

Tips on how to make it less likely that your LD is deemed to be a penalty

Although each case is decided on its facts, there are a number of guiding principles to be taken into account when drafting an LD clause, including:

  • avoid specifying sums payable upon breach which are so high that they cannot be seen as commercially justifiable or a genuine pre-estimate of loss
  • different types of breach should generally attract payment of different sums in order to be regarded in each case as a genuine pre-estimate of loss
  • if the primary obligation is payment of a particular sum, then breach of this clause should not usually give rise to a 'penalty' payment of a much higher sum
  • keep your calculations to show you have tried to assess likely damage for a particular breach
  • include contractual wording to say that the parties agree that the sum is a genuine pre-estimate of loss and not a penalty (although not decisive, this kind of wording can at least be persuasive to the courts)
  • if drafting a take or pay clause, consider whether the specified sum is commercially justifiable, in the light of the High Court's recent judgments stating that such clauses are subject to the rule against penalties