Following on from our last blog post which dealt with the decision of the Parking Eye case, this blog focuses on the other appeal case dealt with at the same time, which also concerns liquidated damages and penalty clauses.
Liquidated damages clauses can be a useful ‘tool’ in commercial agreements, providing that a certain specified sum of money will be payable by one (‘guilty’) party to the other (‘innocent’) party where there has been a particular breach of contract. So, for example, they can be used when there is a delay in completion of a particular service or when a service fails to meet a certain standard.
One big plus for liquidated damages clauses is that they can give the parties to a contract a greater degree of certainty, as you will know how much you can recover (or how much you will have to pay) if a certain type of breach occurs.
However there is a danger that, if they are not drafted correctly or considered properly, then they may be construed as a ‘penalty clause’, and therefore unenforceable under English Law.
So what do I need to know to make sure that I have an enforceable liquidated damages clause rather than a penalty clause?
It is well established law that a provision which constitutes a penalty is unenforceable, and the conventional approach to determining whether a provision is a penalty is to distinguish it from a liquidated damages clause, which is enforceable if it is a genuine pre-estimate of loss.
However in the recent case  the court ‘moved the goal-posts’ for how to identify a penalty clause and has set out a more modern and flexible approach for dealing with such clauses.
A dispute arose following the sale of a majority shareholding in an advertising and marketing communications company. The share purchase agreement included a number of restrictive covenants which the seller breached and which the purchaser sought to enforce. The seller, amongst other things, argued that these provisions were unenforceable as penalties.
In this case the Court felt that the restrictive covenants were necessary to protect the buyer of the shares and as such were not penalty clauses, as they were defending those interests. The relevant contractual clauses did not engage the rule against penalties and, therefore, were not unenforceable penalties.
More importantly however this decision provides much needed clarity in this complex area of law and confirms that the ‘genuine pre-estimate of loss v penalty’ test is simply a consideration which may not apply to every case where the law on penalties applies. Instead ask yourself the following questions:
- Does the innocent party have a legitimate interest in enforcing the obligation under the clause?
- If so, does the clause impose a detriment which is out of all proportion to that legitimate interest?
- Is there commercial justification for the provision?
- Is the provision extravagant or oppressive?
- Was the provision negotiated on a level playing field?
We can all give some thought to these when drafting any liquidated damages clauses into our commercial agreements.
So, where does this leave me?
Hopefully this judgment will give more flexibility to commercial parties negotiating contracts to decide what the consequence of a breach should be, and in turn should install more confidence that what the parties agree will be enforceable.
When negotiating contracts focus on the commercial rationale for including any such provisions and whether the clause proportionately protects a legitimate business interest, and ensure that it is not extravagant or unconscionable in effect. When carrying out this exercise also bear in mind that, in a contract negotiated between parties of equal bargaining power, it is presumed that the parties themselves are the best judges of what is a legitimate consequence of breach!
Therefore if you want protection of a liquidated damages clause then give some thought to the questions above before drafting, and speak to one of our specialist team members to advise you on the appropriate wording of your clauses, to reduce the risk of them being challenged as a penalty clause. If you are on the receiving end of a liquidated damages clause then make sure that you are comfortable with the commercial justifications made for including such a clause, and seek legal advice if you are unsure.
We are yet to see if this modern approach to penalty clauses will make it more difficult to strike down a clause as a penalty in business agreements but watch this space…
For more information, email firstname.lastname@example.org.
 Cavendish Square Holdings BV (Appellant) v Talal El Makdessi (Respondent)