Liquidated damages clauses allow parties to a contract to specify the amount of damages that will be payable in the event of any future breach of contract. At the time of formation of the contract it is usually the case that neither party envisages that there will be any breach of contract and in practice, therefore, it is often the case that the offending party seeks to challenge the enforceability of the clause if there is any subsequent breach. Such a challenge is often on the basis that the damages as specified in the contract are excessive in amount thereby rendering the clause a penalty and thus, unenforceable.
Generally, the courts do look to uphold liquidated damages clauses, particularly in commercial contracts. However, any clause may be at risk of being found to be a penalty clause if:
- The pre-determined damages sum is considered to be an unreasonable estimate of the probable loss likely to have been suffered by the innocent party; or
- The inclusion of the clause in the contract has been used by one party to exert pressure on the other.
Whilst the courts will generally uphold liquidated damages clauses, the onus is on the party wishing to assert that a clause is not penal in nature to show how it was arrived at. Prevailing circumstances at the time of the contract are therefore relevant factors to be considered.
The question of whether a liquidated damages clause is a penalty or not has been debated for many years. Indeed, the leading case remains a case which dates back to 1915, namely Dunlop Pneumatic Tyre Company Ltd V New Garage & Motor Co Ltd. However, two more recent cases have re-visited the subject once again.
In Alfred McAlpine Capital Projects Ltd v Tilebox Ltd 2005, Tilebox purchased a substantial commercial property with the intention of stripping it to its core and refurbishing it. Under its funding arrangements, Tilebox was to receive a development completion payment and a management fee. The development completion payment was calculated by reference to a complicated contractual formula. Critically, one factor was delay in completion of the project with the development completion payment being progressively reduced if completion was delayed.
On completion of its funding arrangements, Tilebox entered into a separate building contract with McAlpine. That contract included a liquidated damages clause providing for £45,000.00 per week to be paid by McAlpine to Tilebox in the event of delay in completion. This figure, which was accepted by McAlpine during following negotiations, was the minimum weekly rental value of the building once completed.
Completion of the building project was significantly delayed and McAlpine sought a declaration from the court that the liquidated damages clause was a penalty and thus, unenforceable. Tilebox contended that the damages figure was a reasonable pre-estimate of its damages at the time of formation of the contract and sought to rely on the reduction that it would receive in respect of the development completion payment in support thereof.
Reviewing the previous authorities the court made the following observations:
- In previous cases judges have either considered:
(i) whether there is an unconscionable or extravagant disproportion between the damages specified in the contract and the actual damages likely to be suffered or
(ii) whether the level of damages specified was reasonable.
- Although many previous authorities used the phrase “genuine pre-estimate” of loss, the test does not turn upon the genuineness or honesty of the party or parties who made the estimate. The court found that the test was objective, although some regard should be had to the thought processes of the parties at the time they entered into the contract.
- There existed an anomaly within the law of contract because any finding that a clause was a penalty and thus unenforceable meant the courts were not giving effect to clauses that had been agreed in commercial circumstances by parties of equal bargaining power.
- Of all the previous authorities only 4 cases were commercial cases where a liquidated damages clause was held to be a penalty. In each of these 4 cases there was in fact a wide gulf between the level of damages stated in the contract and the level of damages likely to be suffered.
Having regard to the above factors, the court found in favour of Tilebox. At the time of creation of the contract Tilebox’s weekly foreseeable losses arising from delay were greater than £45,000 a week. The stipulated damages figure therefore represented a reasonable and conservative pre-estimate of damages.
In Volkswagen Financial Services (UK) Ltd v Ramage 2007, however, the liquidated damages clause was held to be a penalty and thus unenforceable, Ramage hired a car from VW for a fixed period of 36 months pursuant to a hire purchase agreement. By that agreement he agreed to pay a fixed sum per month to VW for the hire of the vehicle. He also agreed to pay the total amount of rental payments for the entirety of the hire period, less any sums paid to date and any rebate due, in the event of repudiation of the contract.
Ramage defaulted on the monthly instalments payable under the agreement and VW therefore wrote to him stating that his failure to meet the monthly instalments showed an intention not to be bound by the agreement and that as a result he had repudiated the contract. By that letter VW also made it clear that it accepted his repudiation and accordingly, sought to recover possession of the vehicle together with payment of the damages as stipulated in the liquidated damages clause. The total sum sought was £10,428.
Ramage alleged that the clause in question was penal in nature and thus enforceable. At first instance, this was rejected by the court. The court found that the calculation of VW’s actual loss in the event of early recovery of the vehicle was not an easy exercise given that VW would have to take into account variable factors such as a vehicle’s mileage and condition which might affect its value. Having regard to this, the court considered that the clause in question meant that the sum as calculated was a genuine pre-estimate of the loss that VW was likely to suffer and accordingly, it upheld the clause and granted judgment in VW’s favour.
Ramage appealed. Allowing the appeal, the court held that the clause did not provide for a genuine pre-estimate of loss and was in fact a penalty and thus, unenforceable, although Ramage did remain liable for some payments under the agreement. In deciding that the clause was penal the court had regard to the fact that the agreement provided for the entirety of the future rental payments to be made with no allowance being made for the residual value of the car notwithstanding the fact that it had been returned earlier than would otherwise had been the case if Ramage had not defaulted on the payments.
Liquidated damages clauses can be very attractive, particularly in a commercial contract. They can be very effective and have been successfully deployed within the construction industry. It is often not possible at the time of formation of the contract to accurately predict the precise level of damages arising from a breach and it is helpful for parties to know therefore what damages would be payable in the event of a breach. Furthermore, if there is a breach then the innocent party would not have the difficulty and expense of proving actual loss and recovery of damages can therefore often be much easier and quicker. Liquidated damages clauses also reinforce certain contractual obligations and can therefore provided added incentive to parties to ensure that no breach of contract occurs. Nonetheless they can be open to challenge and careful consideration therefore needs to be given to the damages sum claimed in each and every case so as to ensure that the specified damages is as close as possible to the loss likely to be suffered in the event of a breach.
Consistent with our policy when giving comment and advice on a non-specific basis, we cannot assume legal responsibility for the accuracy of any particular statement. In the case of specific problems we recommend that professional advice be sought.