Liquidated damages clauses and penalties – a watered down principle?
5 November 2015
Pre-determining loss and damage for certain breach events is common place in ICT/outsourcing contracts and avoids the need for the innocent party to (i) prove the causal link between the breach and the loss suffered, and (ii) quantify it. It provides certainty for all concerned. Liquidated damages clauses are intended to provide a genuine pre-estimate of the loss suffered by the innocent party and are therefore compensatory in nature. Penalties on the other hand are a predetermined amount payable upon breach set at such a level that their impact is inevitably penal rather than compensatory.
For this reason, it is a long established principle of common law that penalties are unenforceable. The distinction between liquidated damages and penalties has been a fertile ground for disputes as the Court has sought to reconcile the common law principle with allowing parties to negotiate their own contractual terms.
A tale of two cases
In July 2015, the Supreme Court heard two cases which focused on whether a particular payment was a penalty or not, and which raised the question as to whether the whole area of penalties should be reviewed.
- El Makdessi v Cavendish Square Holdings  EWCA Civ 1539: Under a sale purchase agreement relating to the purchase of Mr Makdessi’s company by Cavendish, Mr Makdessi committed a breach of the agreement, which triggered the application of two clauses. Under the first, he would lose over $44m in deferred consideration, and under the second, the shareholder option price available to him was reduced. Mr Makdessi argued that these clauses were penal and not genuine pre-estimates of loss, nor commercially justifiable.
- ParkingEye Limited v Barry Beavis  EWCA Civ 402: Mr Beavis overstayed in a 2 hour free car park and received a fine of £85 as a result. He argued that this was not a genuine pre-estimate of loss as if he had left at the correct time the parking space would either (i) have remained vacant or (ii) been occupied by another car for a period of free parking. Either way, ParkingEye would not have suffered loss of £85. The fine was a deterrent in nature rather than compensatory.
The Supreme Court has rejected both these contentions and set out its views on both cases, as well as the law relating to penalties generally, over the course of a 124 page judgment.
- In Makdessi, the price formula was held to have a legitimate function which had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective of acquiring the business. The amount in question was not exorbitant in its nature and impact. Cavendish had a substantial legitimate interest to protect which was dependent upon the continued loyalty of the seller through his compliance with the restrictions on him which he breached. The Court was also influenced by the fact that both parties were highly experienced in commercial affairs and had been advised in the preparation of the contract by reputable solicitors.
- In ParkingEye, the Court held that the £85 fine had two purposes: (i) to manage the efficient use of parking spaces in the interest of retail outlets and other shoppers, and (ii) to provide an income stream to enable ParkingEye to meet the costs of operating the scheme. Imposing a fine by way of deterrence is not penal if there is a legitimate interest in influencing the conduct of the other party, which cannot be achieved purely by the right to claim damages for breach of contract.
- The true test for whether a term is a penalty is to assess whether the detriment on the contract-breaker is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation in question.
What does the judgment mean for you?
- The rule that a penalty is unenforceable is still good law in England and Wales, but arguing that a clause is penal will likely be more difficult in the future given this judgment. The Supreme Court has accepted that liquidated damages can be more than a genuine pre-estimate of loss and can in fact protect a legitimate commercial interest. Therefore, when drafting, be clear as to what is to be compensated – loss following breach or something wider.
- The prudent party seeking to include a liquidated damages provision in a contract should record an explanation of the amount and why it represents either (i) a genuine pre-estimate of loss or (ii) a reasonable and proportionate protection of a legitimate commercial interest which can be used to rebut any challenge to the provision. For clarity, there is no reason why this cannot be briefly explained in the contract itself.
- It is arguable that the protection of a legitimate commercial interest is limited to “commercial cases” or where the parties are bargaining on equal terms or represented by lawyers. The Court placed much emphasis on the fact that the terms in Makdessi were specifically negotiated between the parties.