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Liquidated Damages & Penalty Clauses in Contract Law – A Brief Analysis

Introduction In a contract, parties can provide for damages to be paid on the occurrence of a breach of contract. It is noteworthy that such provisions do not exclude the application of the general rule that damages for breach are intended to compensate for the actual loss sustained by the innocent party and courts have reserved the power to regulate such provisions.

These agreed damages clauses come in variety of forms such as provisions for payment, formula for determination, etc. The sum fixed by the parties based on such clauses would either be considered as liquidated damages or penalties. If the sum fixed by the parties is a genuine pre-estimate of the loss that will be caused to the innocent party if the contract is breached by the other party, then this will be considered as a liquidated damages clause. The innocent party is entitled to recover such damages from the other party without proving the actual damages suffered as a result of the breach. On the other hand, if the sum was fixed in terrorem i.e., in order to frighten the other party into performing the contract rather than breaking it the provision will be considered to be a penalty. Since penalty clauses are not enforceable the innocent party can only claim damages for the actual loss suffered as a result of the breach. Previous Case Law on Liquidated Damages and Penalties

This vital question as to whether a conventional sum is liquidated damages or a penalty has been discussed in various decided cases. The question is one of construction, to be decided upon the terms and inherent circumstances of each particular contract, judged as at the time of making the contract, not as at the time of breach.

The distinction between penalties and liquidated damages depends on the intention of the parties to be gathered from the whole contract. If the intention is to secure performance of the contract by the imposition of a fine or penalty, then the sum specified is a penalty; but if, on the other hand, the intention is to assess the damages for breach of the contract, it is liquidated damages.

It should also be noted that when construing the terms ‘penalty’ and ‘liquidated damages’ the Courts will not be bound by the phraseology used by the parties in the contract.The expressions used must not, however, be disregarded, and if for instance, the sum is made payable as a penalty the onus of disproving that this is its correct character lies on the party who claims that it was intended to be liquidated damages. The burden of proving that the specified sum is a penalty lies upon the party who is sued for the recovery of the sum.The main purpose of including an agreed damages clause in a contract is to achieve certainty. Hence, where the parties are able to protect themselves, the Court is likely to take the view that what the parties have agreed should normally be upheld and to take care not to set too stringent standard which could defeat that purpose.

Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd is one of the leading cases on liquidated damages and penalties in Contract Law. The House of Lords held that the sum fixed by the parties was a genuine pre-estimate of the damage which might ensue and not a penalty.

In his judgment Lord Dunedin laid down the following rules;

  • It will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.

  • It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid.

  • There is a presumption (but no more) that it is a penalty when a single lump sum is made payable by way of compensation, on the occurrence of one or more of all of several events, some of which may occasion serious and others but trifling damage.

  • It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility.

The judgment of Lord Dunedin has rationalized and consolidated the case law up to that point in time and has provided a foundation for modern law. Over the years, in subsequent cases, the above principles have achieved the status of a quasi-statutory code. Therefore, for almost 100 years the test for determining whether a clause was a penalty clause or not was broadly based on the principles established in Dunlop case. The Legitimate Interest Test The Landmark Judgment in the case of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis, the English Supreme Court changed the law relating to liquidated damages and penalty clauses and introduced a new test for contractual penalty clauses.

Both these cases were appeals from the Court of Appeal. The first appeal, Cavendish Square Holding BV v Talal El Makdessi, raised the issue in relation to two clauses in a substantial commercial contract and the second appeal, ParkingEye Ltd v Beavis, raised the issue at a consumer level.

The Supreme Court rejected the traditional test that a clause will be a penalty if it is not a genuine pre-estimate of loss or if its purpose is to deter a breach of contract. The new test for a penalty clause is whether the contractual remedy for breach is out of all proportion to the innocent party’s legitimate interest in enforcing the obligations of the counterparty under the contract.

The ‘legitimate interest test’ has been put forward by the Lords of the Supreme Court in their judgments in subtly different ways;

“The true test is whether the impugned provision is a secondary obligation 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” “The correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract.”

The court also commented that, in a straightforward damages clause, the innocent party’s interest will rarely extend beyond compensation for breach, hence the traditional test will usually be adequate to determine the validity of the clause. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.

Conclusion The decision of the Supreme Court in the Cavendish and Beavis Appeals has introduced a more modern and flexible test replacing the old traditional test in Dunlop relating to penalty clauses. The new test is wider than the old one as it allows for the consideration of legitimate interests of the parties to enforce contractual obligations which would extend beyond the desire to recover compensation for a breach or the deterrence of a breach of contract.




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