It is a long-established principle of contract law that a liquidated damages clause is enforceable provided the sum payable represents a genuine pre-estimate of loss and does not amount to a penalty.
In Talal El Makdessi v Cavendish Square Holdings BV & Anor  EWCA Civ 1539, the Court of Appeal applied a two stage test in its assessment of whether a liquidated damages clause constituted a penalty.
When previously determining if a clause was a penalty, the courts looked at whether the sum which would be paid in the event of a breach of contract was extravagant and unconscionable, in which case the court would find the clause an unenforceable penalty; but if it was a genuine pre-estimate of loss, then it could be recovered.
The Court of Appeal in Talal El Makdessi applied a second stage to this test and considered whether the clause was commercially justifiable. The clause in question sought to restrict Talal El Makdessi from competing with the business he had sold under the contract and provided for the payment of a sum of money in such circumstances. It was considered to be unconscionable as the sum forfeited by Talal El Makdessi was far greater than the maximum damages the purchaser could have recovered by means of a contractual damages claim as the clause required him to transfer shares at what would most likely be an undervalue. The court went further, to consider whether the clause was commercially justifiable, by serving an economic function in which case the clause might be found to be enforceable. The court considered that the dominant purpose of the clause was to deter breach by the seller and was not commercially justifiable, therefore it was legally unenforceable.
The Court of Appeal made it clear in its judgment that each case would turn on the individual circumstances and facts surrounding the particular agreement, however this two stage, modern approach to assessing whether a clause is a penalty is a clear evolution of the long-standing legal principle.
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