Potential Pitfalls of Liquidated Damages Clauses in Commercial Contracts

A liquidated damages clause in a commercial contract seeks to pre-set the damages recoverable for a specified breach of contract.

One advantage of this is that it gives the parties the certainty of a pre-set amount, and so reduces the risks and burdens of litigation.

However, the danger with such clauses is that they risk challenge as offending the rule against penalties. The long-standing authority concerning penalties was that such clauses were unenforceable unless they represented a genuine pre-estimate of loss.

However, since the leading case of ParkingEye Ltd –v– Beavis, it is established that this is no longer the correct test.

The Current Position

Following the decision in ParkingEye Ltd –v– Beavis, the current position is that if the clause represents a primary obligation (e.g. an obligation to pay a fixed sum on a specified date), it is not a penalty, but if it represents a secondary obligation (e.g. it is triggered on breach of a separate contractual obligation), then it is subject to the rule against penalties.

Unfortunately, it is not always clear cut whether the clause is a secondary obligation (the opinion was divided in ParkingEye Ltd –v– Beavis), and the safest approach is to assume that the rule against penalties will apply.

The current position requires that the following factors are considered:

• If the amount claimed is extravagantly high in comparison to the amount of the loss that the claimant would realistically suffer, then the clause is a penalty and is unenforceable.
• If the amount claimed is not extravagantly high, then the clause is not a penalty and is potentially enforceable with the following additional factors being relevant:
• Whether the clause is commercially justifiable in protecting a legitimate interest of the claimant and has been freely negotiated by parties of comparable bargaining power.
• Whether the term is designed specifically to be penal rather than being a genuine compensatory amount. Such clauses that are included for this reason are open to challenge, but the decision in ParkingEye Ltd –v– Beavis made it clear that this is not always the case.

For the above reasons, great care is needed when drafting contractual liquidated damages clauses to ensure that the intended effect will be realised.

The Company and Commercial team at Wilson Browne Solicitors regularly advises on the preparation and negotiation of complex commercial contracts in multiple market sectors, including contracts which include liquidated damages provisions.

For a confidential and no obligation initial discussion about how we may be able to help, please contact the Company and Commercial team on 0800 088 6004 or fill out our online form.