Difference between a Penalty and Liquidated Damages under English Contract Law

Under the English legal system, the courts are generally quite willing to allow parties of equal standing to freely negotiate a contract. This policy of non-intervention extends to most aspects of an agreement, mainly to prevent parties from backing out of what they may perceive as a bad deal. However certain types of clauses, including penalty clauses, are not permitted, regardless of the intent of the parties

Incentives for the supplier to perform are common in commercial contracts. These incentives may take the form of a carrot – such as a percentage uplift in the price to be paid if a project is completed ahead of time, or a stick – such as the right to terminate if a supplier persistently breaches the terms of the contract.

However, the most common incentive is the “liquidated damages” (or LD) clause. In a contract for services, the supplier may be required to perform to an agreed service level (or SLA). If the supplier fails to perform to the agreed metrics, then they will be in breach of contract, which entitles the customer to claim damages, but may not be serious enough to allow the customer to terminate the agreement.

Assessing and claiming damages can be a protracted and messy affair, which is where LDs come in. The parties can agree, in the contract, that some breaches attract the payment of an LD to compensate the customer for damages occasioned by the breach. These LDs must be a fair and genuine pre-estimate of the loss the customer would suffer and are assessed from when the parties enter into the contract (not when the breach occurs). The idea is to provide a quick and easy way to compensate the customer for loss, rather than punishing the supplier for not performing.

If the amount of LDs claimed is excessive, it risks being struck out as an unenforceable penalty clause. A party should not make a profit from the other party’s breach. It doesn’t matter what the clause is called, the court will always look behind the title or language to assess the actual impact of the clause when deciding whether it is a penalty or appropriate LDs.

Recent case law also suggests that the courts are taking a more commercial and flexible approach in determining whether a clause is an LD or a penalty, especially where the genuine pre-estimate of loss is difficult (such as in large scale, complex construction and public procurement contracts).

In summary, to help prevent a clause from being struck out as a penalty: (a) the amount levied must be a genuine pre-estimate of loss; (b) if it’s difficult to assess the likely loss, the parties should ensure that damages are commercially reasonable; (c) keep a note of any discussions, meetings and correspondence that passed between the parties during negotiations which may help prove the parties’ intentions; and (d) ensure that the damages assessed are proportionate to the breach – a single sum applied to both minor and major breaches is more likely to fall foul of the rules.

Lastly, if the parties are of unequal bargaining strength, the courts are more likely to intervene to set aside a clause that may otherwise not be considered punitive. As such, larger organisations should take greater care in making an assessment of their likely loss, or consider alternative risk-mitigation strategies.