Learning Outcomes
This article outlines the rules relating to agreed damages clauses in contracts. For the SQE1 assessments, you need to understand the difference between a liquidated damages clause, which is generally enforceable, and a penalty clause, which is generally unenforceable. You will need to be familiar with the legal tests applied by the courts to distinguish between the two types of clauses, particularly the principles established in key case law. This knowledge will allow you to identify the enforceability of such clauses in client scenarios presented in SQE1 multiple-choice questions.
SQE1 Syllabus
For SQE1, you are required to understand how contracts can provide for specific sums payable upon breach, and the legal framework governing these provisions. It is likely you will need to apply the rules distinguishing enforceable liquidated damages clauses from unenforceable penalty clauses to practical scenarios.
As you work through this article, remember to pay particular attention in your revision to:
- The definition and purpose of liquidated damages clauses.
- The definition and purpose of penalty clauses.
- The legal tests used to differentiate between liquidated damages and penalty clauses, including the concepts of 'genuine pre-estimate of loss' and the modern 'legitimate interest' test.
- The consequences of a clause being classified as a penalty.
- Key case law such as Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd and Cavendish Square Holding BV v Makdessi.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the primary difference between a liquidated damages clause and a penalty clause?
- True or false? A clause requiring a payment vastly in excess of any possible loss caused by a breach is likely to be enforceable as liquidated damages.
- Which landmark case introduced the modern test focusing on 'legitimate interest' and proportionality for assessing penalty clauses?
- If a court determines a clause is a penalty, what remedy is typically available to the innocent party?
Introduction
Parties negotiating a contract often wish to achieve certainty regarding the consequences of a potential breach. One way to do this is to include a clause specifying a fixed sum of money payable by the contract-breaker upon a particular breach occurring. Such clauses aim to pre-determine the damages payable, avoiding the need for the innocent party to prove their actual loss and the potential complexities and costs associated with quantifying damages at common law.
However, the courts exercise control over these clauses. English law distinguishes between liquidated damages clauses, which are generally enforceable, and penalty clauses, which are generally unenforceable. Understanding this distinction and the tests applied by the courts is essential for advising clients on the validity of such terms.
Liquidated Damages Clauses
Key Term: Liquidated Damages Clause
A term in a contract that stipulates a specific sum of money to be paid by the party in breach to the innocent party upon a particular breach occurring, representing a genuine pre-estimate of the likely loss.
The purpose of a liquidated damages clause is compensatory, not punitive. It aims to provide a reasonable assessment, made at the time of contracting, of the loss likely to flow from the specified breach. If a clause is deemed to be a valid liquidated damages clause, the stipulated sum is payable upon the breach occurring, regardless of the actual loss suffered by the innocent party. The innocent party cannot claim more than the specified sum, even if their actual loss is greater, nor can the party in breach argue that less should be paid because the actual loss was smaller.
Penalty Clauses
Key Term: Penalty Clause
A term in a contract that stipulates a sum payable upon breach which is extravagant and unconscionable in comparison to the greatest loss that could conceivably follow from the breach, designed to deter breach rather than compensate for loss.
Unlike liquidated damages, a penalty clause is designed to punish the breaching party or act as a deterrent in terrorem (as a threat) against breaching the contract. English courts will not enforce penalty clauses. If a clause is held to be a penalty, it is disregarded, and the innocent party must prove their actual losses and recover damages assessed in the normal way (subject to the rules of causation, remoteness, and mitigation).
Distinguishing Between the Clauses: The Legal Tests
The courts have developed tests to determine whether a clause is a liquidated damages clause or an unenforceable penalty. The label used by the parties (e.g., calling it 'liquidated damages') is not conclusive.
The Traditional Test: Genuine Pre-Estimate of Loss
Historically, the key test was whether the stipulated sum was a 'genuine pre-estimate of loss' likely to be caused by the breach, judged at the time the contract was made. In Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, Lord Dunedin outlined guidelines:
- A sum is likely a penalty if it is 'extravagant and unconscionable' compared to the greatest conceivable loss.
- A sum is likely a penalty if the breach consists only of not paying a sum of money, and the stipulated amount is greater than the sum that ought to have been paid.
- There is a presumption (rebuttable) that it is a penalty if a single lump sum is payable upon the occurrence of one or more events, some serious, some trifling.
- It is no obstacle that precise pre-estimation is difficult; this may be exactly when parties agree a sum.
The Modern Test: Legitimate Interest and Proportionality
The Supreme Court reformulated the test in Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67. The focus shifted from the 'genuine pre-estimate' concept to whether the clause protects a legitimate interest of the innocent party and whether the detriment imposed on the breaching party is proportionate to that legitimate interest.
Key Term: Legitimate Interest
In the context of penalty clauses, an interest beyond simply compensating for financial loss, which the innocent party is justified in protecting through the clause (e.g., maintaining goodwill, ensuring operational efficiency).
The modern test asks:
- Does the clause impose 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?
If the clause protects a legitimate interest and the detriment is not 'extravagant', 'exorbitant', or 'unconscionable' in comparison to that interest, it is likely enforceable as a liquidated damages clause. If it is out of all proportion, it is likely an unenforceable penalty.
Worked Example 1.1
A construction contract provides that the contractor must pay the employer £10,000 for every week of delay beyond the agreed completion date. The project is complex, and accurately predicting the employer's losses due to delay (e.g., loss of rental income, disruption to business) is difficult. Is this clause likely enforceable?
Answer: This clause is likely enforceable as liquidated damages. £10,000 per week might represent a genuine attempt to pre-estimate the loss caused by delay in a large construction project, where quantifying actual loss would be complex. It protects the employer's legitimate interest in timely completion. Unless the sum is shown to be extravagant or unconscionable compared to the likely losses, it probably satisfies the modern test.
Worked Example 1.2
A software licensing agreement states that if the licensee uses the software on more than the permitted five devices, the licensee must pay a one-off sum of £1,000,000. The licensor's actual loss from such a breach would typically be the cost of additional licences, amounting to perhaps £5,000. Is this clause likely enforceable?
Answer: This clause is likely an unenforceable penalty. The sum of £1,000,000 appears extravagant and out of all proportion to any legitimate interest the licensor might have in enforcing the five-device limit. The greatest conceivable loss appears significantly lower. It seems designed primarily to deter breach rather than compensate for loss.
Exam Warning
Do not rely solely on the label given to a clause by the parties. A clause labelled 'liquidated damages' can still be a penalty if it fails the legal tests, and vice versa (though less common). Focus on the substance and effect of the clause compared to the legitimate interests and potential losses.
Effect of a Clause Being a Penalty
If a clause is deemed a penalty, it is unenforceable beyond the actual loss suffered. The innocent party is not prevented from claiming damages for the breach, but they must prove their actual loss in the usual way, subject to the rules on causation, remoteness, and mitigation. They cannot recover the penalty sum stipulated in the contract.
Statutory Controls
While the primary control over penalty clauses comes from common law, statutory provisions, particularly in consumer contracts, may also be relevant.
- Consumer Rights Act 2015: Part 2 of the CRA 2015 subjects terms in consumer contracts to a fairness test. A term requiring a consumer to pay a disproportionately high sum in compensation could be deemed unfair and therefore not binding on the consumer (see Sch 2, Part 1, para 6).
Revision Tip
Remember that the modern test from Cavendish is broader than the traditional Dunlop test. Consider not just financial loss, but any other legitimate commercial interests the innocent party might be protecting when assessing proportionality.
Key Point Checklist
This article has covered the following key knowledge points:
- Liquidated damages clauses specify a pre-agreed sum payable on breach, representing a genuine pre-estimate of loss.
- Penalty clauses specify a sum payable on breach that is designed to deter breach and is disproportionate to any legitimate interest or likely loss.
- Liquidated damages clauses are generally enforceable; penalty clauses are generally not.
- The traditional test focused on whether the sum was a 'genuine pre-estimate of loss' (Dunlop).
- The modern test asks if the detriment imposed by the clause is out of all proportion to any legitimate interest of the innocent party (Cavendish).
- If a clause is a penalty, the innocent party must prove their actual loss to recover damages.
- Statutory controls, particularly the Consumer Rights Act 2015, may also apply, especially in consumer contracts.
Key Terms and Concepts
- Liquidated Damages Clause
- Penalty Clause
- Legitimate Interest
