Liquidated damages and penalties

It is possible, and common in business contracts, for the parties to an agreement to make provisions for possible breach by stating in advance the amount of damages that will have to be paid in the event of any breach occurring. Damages under such a provision are known as liquidated damages. They will only be recognised by the court if they represent a genuine pre-estimate of loss and are not intended to operate as a penalty against the party in breach. If the court considers the provision to be a penalty, it will not give it effect but will award damages in the normal way, that is, unliquidated damages assessed by the court.

In Dunlop v New Garage & Motor Co the plaintiffs supplied the defendants with tyres under a contract designed to achieve resale price maintenance. The contract provided that the defendants had to pay Dunlop £5 for every tyre they sold in breach of the resale price agreement. When the garage sold tyres at less than the agreed minimum price, they resisted Dunlop’s claim for £5 per tyre, on the grounds that it represented a penalty clause. On the facts of the situation, the court decided that the provision was a genuine attempt to fix damages and was not a penalty. It was, therefore, enforceable.

In deciding the legality of such clauses, the courts will consider the effect, rather than the form, of the clause, as can be seen in Cellulose Acetate Silk Co Ltd v Widnes Foundry Ltd  In that case, the contract expressly stated that damages for late payment would be paid by way of penalty at the rate of £20 per week. In fact, the sum of £20 was in no way excessive and represented a reasonable estimate of the likely loss. On that basis, the House of Lords enforced the clause, in spite of its actual wording.

In Duffen v FRA Bo SpA it was held that a term in an agency contract which established so-called ‘liquidated damages’ for the dismissal of the agent at £100,000 was, in fact, a penalty clause and could not be enforced. This was in spite of the fact that the agreement specifically stated that the £100,000 was ‘a reasonable pre-estimate of the loss and damage which the agent will suffer on the termination of theLtd v agreement’. In reaching its conclusion, the court held that although the wording of the agreement was persuasive, it was outweighed by the fact that the level of damages did not alter in proportion to the time remaining to be served in the agreement. The claimant was consequently only allowed to claim for normal damages, although these could be augmented under the Commercial Agents Regulations 1993

The whole question of penalty clauses is fraught. It is obviously advantageous, in a business context, for the parties to a contract to know with certainty what the financial consequences of any breach of the contract will be, so as to allow them to manage their risk properly. However, the possibility of the courts subsequently holding a damages clause to be punitive introduces the very uncertainty that the clause was designed to avoid.

In any case, why should businesses not be bound by clauses, as long as they have been freely negotiated? This point leads to a comparison of liquidated damages clauses and limitation and exclusion clauses. Usually, penalty clauses are thought of as overestimating the damages, but it should be considered that such a pre-estimation may be much lower than the damages suffered, in which case the clause will effectively operate as a limitation clause. It would surely be better all round if the liquidated damages/penalties clause question was subject to a similar regime as regulates exclusion/limitation clauses under the Unfair Contract Terms Act 1977. The courts would then be required to examine whether the clause was the product of truly free negotiation and not the outcome of an abuse of power, in which case it would be effective, or, alternatively, whether it was imposed on one of the parties against their wishes, in which case it would be inoperative.