The sums to be charged can be significant and it is therefore not surprising that the paying party frequently contests their validity; one of the most common reasons for dispute is that the clause on liquidated damages is not efficient as it amounts to a ‘ penalty. ‘
What are Liquidated Damages?
Liquidated damages are pre-agreed amounts of compensation to be paid by the ‘ contract breaker ‘ to the ‘ innocent ‘ party to a contract on the occasion of clear breaches of the contract; liquidated damages, for instance, are generally incurred if there is a delay in completing the works by the agreed date of completion.
The Purpose of Liquidated Damages
Liquidated damages provide certainty and avoid a dispute over the amount to be deducted for the infringement, as the right to be paid liquidated damages arises automatically in the event of a specified infringement.
When liquidated damages are not agreed in advance, the normal recourse for the innocent party in the case of a breach of contract is the payment of general damages, i.e. a sum of compensation (to be determined by the Court) to be paid by the attacker to the innocent party. The innocent party must be able to prove the loss in order to be successful in a case for general damages and that this loss is caused by the breach of contract.
Care should be taken to ensure that liquidated damages do not amount to a penalty; a penalty is effectively a clause punishing a party for its contractual infringement. Instead of acting as a punishment, liquidated damages should provide an alternative to performing the contractual obligation in question.
When do Liquidated Damages amount to a Penalty?
It used to be the case that, in order to avoid being a penalty, liquidated damages had to be a’ genuine pre-estimate of loss’ that the innocent party would suffer in the event of a specified contract breach. However, in 2015, when considering the cases of Cavendish Square Holding v El Makdessi; ParkingEye v Beavis, the Supreme Court clarified the law in this area. The Supreme Court stated in its judgment that:
-The “true test” to determine whether a clause amounts to a penalty is whether “it is a secondary obligation (e.g. a liquidated damages clause) 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.”; (emphasis added)
-The innocent party’s interest is in performance or some suitable alternative to performance; not simply in punishing the contract-breaker;
-compensation alone may not necessarily be the only legitimate interest that the innocent party may have in the performance of the contractor breaker’s primary obligations; and
-In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption would be that the parties themselves are the best judges of what is legitimate in a clause dealing with the consequences of a breach.
As a result of the decision of the Supreme Court in Cavendish Square Holding v El Makdessi; ParkingEye v Beavis, the fact that a clause on liquidated damages may require the contract breaker to pay more than a’ genuine pre-estimate of loss’ does not necessarily mean that it will be interpreted as a penalty.
The broader interests of the innocent party in satisfying the primary contractual obligations of the breaker will also be taken into consideration (i.e. in order to determine whether there is an economic reason for implementing the clause).
Liquidated Damages Benefit both Employers and Contractors
Many main contractors object to liquidated damages clauses as they can’t see past the principal that it involves them making payment of sums to the employer. However, liquidated damages clauses can be a positive step for a contractor as they act as a limit on the contractor’s liability in the event of the specified default occurring.
By agreeing to a liquidated damages clause contractors know the extent of their liability in the event of the specified default occurring. A well-negotiated liquidated damages figure could result in the contractor saving money when compared to general damages that may be awarded by a court, including the legal costs that the contractor will have needed to spend resolving the dispute.