Liquidated Damages Clause: An Overview

Liquidated Damages Clause

What is a liquidated damages clause?

A liquidated damages (LDS) clause is a provision within a contract whereby the contracting parties specify and agree on a fair and genuine pre-determined sum of money to be paid in the event that one party breaches the contract terms.

The liquidated damages clause ultimately acts as a form of compensation for the party that is negatively affected by the breach of contract. The implementation of such a clause provides a clear understanding between the parties on the consequences and fees payable in the event of a breach.

The clause establishes a fixed amount to be paid to the innocent (ie. non-breaching) party where they do not need to prove the losses they have suffered. This is because the fixed sum detailed in the clause will be a fair and pre-determined amount agreed by both parties to be paid in the event of a breach.

This estimate and fixed amount means that the innocent party avoids costly and time-consuming litigation in which they would have needed to prove their loss to obtain compensation.

It is common to find liquidated damages clauses in commercial and construction contracts, for example, the clause in a construction contract may specify a fixed sum to be paid for each day the construction project is delayed beyond the agreed completion date.

The focus of liquidated damages clauses is on fairly reimbursing the innocent party for the losses they have incurred as a result of any breach, rather than penalising the breaching party.

Liquidated damages clause vs penalty clause

Liquidated damages clauses estimate and represent a fair amount of compensation payable to the non-breaching party in the event the contract is violated, whereas penalty clauses in contracts act more as a punishment to the breaching party.

Penalty clauses are not enforceable by the courts due to the fact they often go beyond that of fair compensation for the breach of contract.

Courts aim to differentiate between the two types of clauses based on the clause’s purposes rather than the terms used in the contract. The court will also consider if the stipulated fixed sum is excessively high compared to the maximum possible loss arising from a potential breach of contract. If the sum is considered to be excessively high then it may be considered a penalty and unenforceable. Similarly, if the breach involves non-payment of a specific sum, the fixed sum shouldn’t be significantly higher.

Establishing whether a clause constitutes a penalty hinges on the court’s contract interpretation, taking into account elements such as the sincerity of the pre-estimated loss, the extent to which the sum is disproportionate in nature and the circumstances at the time of contract formation.

In recent case law, the ParkingEye v Beavis and Cavendish v Makdessi cases both emphasised the courts’ approach to  determining disputes involving liquidated damages and penalty clauses. These cases affirmed that courts will not judge the overall fairness of a contract, but rather that of the reasonableness of the remedy (amount of compensation) for the breach of contract.

In essence, courts will enforce and uphold liquidated damages clauses if they represent a fair estimation of potential losses arising from a breach, but penalty clauses are not enforceable by the court where their purpose primarily focuses on punishing the breaching party rather than compensating the innocent party.

How are liquidated damages clauses drafted?

Liquidated damages clauses are typically drafted with specific language to outline the consequences of a breach of contract and to avoid any penalty interpretation. The general framework for drafting such clauses follows:

  • Identification of parties to the contract: Clearly identify the parties involved in the contract, i.e., the party agreeing to perform the obligation and the party to whom the obligation is owed.
  • Description of obligation: Define the obligation or duty that the party is expected to fulfil under the contract.
  • Stipulation of liquidated damages: Specify the amount of money that will be payable in the event of a breach. This amount should represent a reasonable estimate of the actual damages that might occur due to the breach.
  • Triggering events: Clearly state the conditions or events that would trigger the payment of liquidated damages.
  • Intent language: Include language indicating that the parties acknowledge and agree that the specified amount represents a genuine pre-estimate of damages and is not intended to be punitive.
  • Enforceability clause: A provision should be included stating that the liquidated damages clause is enforceable and does not constitute a penalty under applicable law.
  • Survival clause: Include a provision specifying whether the liquidated damages clause survives termination or expiration of the contract.

Drafting liquidated damages clauses and agreeing the damages for a breach require careful consideration of the specific circumstances of the contract and the potential risks involved. It’s essential to strike a balance between providing certainty and protection for both parties while avoiding the characterisation of the clause as a penalty by the courts.

An experienced commercial solicitor can assist with the drafting of such clauses, ensuring all of the necessary information is included and maximising the prospect that it will be legally enforceable. If you would like expert legal advice on the drafting of a liquidated damages clause then please get in touch with our team at South Bank Legal today.

How can South Bank Legal assist with liquidated damages clauses?

Our team of commercial law solicitors at South Bank Legal can provide expertise in drafting, reviewing and negotiation of liquidated damages clauses to ensure they are legally sound and fair.

Additionally, our solicitors can provide expert legal advice on a wide range of other commercial disputes, including intellectual property disputesshareholder disputes, and breach of contract remedies.

If you would like more legal advice on liquidated damages clauses or wish to discuss any of our services, you can contact us using the form below or telephone 02035765179 for a confidential discussion with one of our solicitors.

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