Penalty Clauses vs Liquidated Damages clauses | for Microsoft Partners

The main difference between a penalty clause and liquidated damages is that the former is intended as a punishment and the latter simply attempts to make amends or rectify a problem.

Delays in commercial transactions can often bring up questions about penalties and liquidated damages.

Here at Law 365 we've realised that there is some confusion when people ask us about them so we've put together this blog to clarify the differences.

What is a penalty clause?

A penalty clause, in simple terms, is a clause within a contract that states that if a party breaches an obligation, that breaching party must pay a pre-agreed amount of money (or provide another remedy) to the innocent party.

As penalties are almost always financial, we are only going to be looking at financial penalties within this blog.

Importantly, to be a penalty, the amount of money must be excessive and disproportionate to the actual expected loss of the innocent party (due to the breach).

Instead of simply compensating the innocent party, the penalty clause punishes the breaching party.

What are liquidated damages?

Liquidated damages, like a penalty clause, is a pre-determined sum to be paid by the breaching party to the innocent party upon a particular breach of the contract.

Liquidated damages are however different. These are not punishments and are rather awards of pre-agreed damages. The purpose is to compensate the innocent party for its anticipated loss suffered due to the breach without the need to go to court, not to penalise the breaching party. These are much fairer towards the breaching party.

Example of Liquidated Damages v Penalty Clause in a contract

Let's imagine that two companies, Company A and Company B, entered into a contract for the supply of certain IT hardware by Company A to Company B.

Liquidated damages in the contract might stipulate that in the event of a failure by Company A to deliver the hardware to Company B by a specified date, that £15.00 is payable for each day the delivery is late.

Alternatively the amount could be a percentage of the goods purchase price i.e. 1% of the purchase price each day. Each would likely be viewed as liquidated damages (depending on the facts of course!) as these payment aren't likely to be excessive.

However, a penalty clause in the contract might stipulate an excessive amount for each week the delivery is late — for example, 200% of the purchase price will be payable each week until the delivery is made, in order to punish the breaching party.

To ensure the clause is not a ‘penalty’ the sum should be a honest reflection of the loss that Company B will likely face in the event of the delay i.e. this could include paying its contractors even though the project cannot yet be started, relocating staff to other projects on short notice and paying their expenses; paying any late fees to its own customer and so on. The amount does not need to be exact, and in reality it rarely is, however Company B must be able to show that they've given some genuine consideration to the anticipated loss and the clause somewhat reflects this loss i.e. is proportionate.

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Can you enforce a penalty or liquidated damages clause?

Under English law, penalty clauses used to exclusively punish a party are unenforceable.

The courts will however uphold a reasonable liquidated damages clause.

3 ways to determine if a clause is a penalty clause or a liquidated damages clause

The difference can be hard to identify. The court will use the case of Cavendish Square Holdings BV v Makdessi together with its companion case, ParkingEye Ltd v Beavis [2015] UKSC 67 to decide if a clause is an unenforceable penalty clause or an enforceable liquidated damages clause.

For a clause to be enforceable, it must satisfy the following:

1. The obligation to pay such amount must be a secondary obligation

   What's the difference between a primary and secondary obligation? I hear you ask.

   Using our scenario above:

   • The primary obligation is for Company A to deliver the IT Hardware to Company B by a certain time, therefore meeting the terms agreed in the contract.

   • The secondary obligation is for Company A to pay to Company B a late payment fee, in the event of a breach of the primary obligation. The obligation of paying for the breach, is secondary to the obligation to meet the delivery date.

   Although it may seem simply enough to identify a primary or secondary obligation, it is not always the case and the courts have stated that they will not be fooled by form or labels. You should therefore take care when reviewing or drafting these types of clause.

2. The innocent party must have a legitimate interest in the performance of the contract

   For example, using our scenario,

   • Company A has contracted with Company B specifically for the supply of certain IT Hardware, the parties have also pre-agreed a particular delivery date (or at least a last possible delivery date) and Company B has most probably now made plans on the basis that the goods will be delivered by that date.

   • Company B therefore has a legitimate interest in getting that IT hardware delivered by the agreed date.

3. The sum must be proportionate and must not be excessive

   This will be largely dependent on the particular circumstances. However, it is unlikely that a sum imposed for a delay in delivering goods by just one day will ever be upheld.

   Each case will depend on the company's individual circumstances.

   For example in a situation where the goods supplied are business critical, i.e. the supply of internet or phone lines to a call centre, it would be perfectly reasonable for a higher fee/percentage to be applied as the consequences would be significant.

Drafting and reviewing a penalty clause

When drafting/reviewing a penalty clause, ask yourself:

Is the clause in question a primary or secondary obligation?

Primary: The clause is not a liquidated damages clause.

Secondary: Is there a legitimate interests/aim behind the contract?

No: This will be a penalty clause and will be unenforceable

Yes: Is that remedy proportionate to those legitimate interests/aims and the likely loss suffered, or is the remedy excessive?

Proportionate: The clause is likely to be a liquidated damages clause and enforceable.

Excessive: The clause is likely to be a penalty clause and unenforceable.

Should I include a liquidated damages clause in my contract?

There are many benefits of including a liquidated damages clause in a contract:

• It allows the innocent party to claim a specified compensation award after a breach has occurred.
• It gives both partis certainty over what to expect if an obligation is breached
  
  
• It can have huge cost advantages as parties do not need to go through the time and expense of a court process to claim for damages, which are of course up to the court to decide after a lengthy assessment of damages!

There are however quite clearly some disadvantages:

• The liquidated damages may not properly compensate the innocent party, these are of course estimates agreed when entering into the contract and the court process may have meant a larger pay-out for that party.

If you do decide to include a liquidated damages clause in your contract, just be careful to ensure that its meets all of the factors outlined above, or it won't be valid.

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