When it comes to drafting contracts, precision and clarity are paramount. Among the crucial components of a contract are clauses that address breaches and their consequences. Two common types of clauses often encountered in contracts are Penalty Clauses and Liquidated Damages Clauses. In this blog post, we will delve into these clauses, explore their differences, and shed light on the legal framework surrounding them.
Understanding Penalty Clauses
A Penalty Clause is usually written into a contract and stipulates that if a person breaks any part of the agreement, they have to pay a disproportionate sum of money to the non-breaching party. The aim is to deter a party from breaking the contract rather than to compensate for the actual loss suffered.
Generally, penalty clauses are unenforceable in English law as they are considered to be a form of ‘penalty’ rather than a genuine attempt to compensate the non-breaching party for their loss. However, there are some exceptions to this rule, for example, if they list a genuine pre-estimate of loss likely to be suffered within a breach or if they are reasonable within the circumstances. Courts are likely to consider a number of factors when determining whether a penalty clause is enforceable, such as the circumstances in which the breach has occurred, the purpose of the clause, the nature of the contract and the penalty amount.
A penalty clause can be written into any contract, but some common examples are, a clause that requires a tenant to pay double the rent should they fail to vacate the premises of a property at the end of a lease, a clause for a contractor to pay a fixed sum of money for each day they are late completing the contract or a clause that stipulates a seller to pay the buyers legal fees if the seller breaches a contract. The landmark case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd (1915) established the principle that a clause can be considered a penalty if it’s used to punish the breaching party rather than compensate for losses incurred.
Understanding Liquidated Damages Clauses
A liquidated damages clause is a contractual provision that specifies the amount of money that one party (the breaching party) must pay to the other party (the non-breaching party) in the event of a breach of contract. Unlike a penalty clause, a liquidated damages clause is intended to be a genuine pre-estimate of the loss that is likely to occur by the non-breaching party in the event of a breach. As a result, liquidated clauses are generally enforceable.
There are things to consider when drafting a liquidated damage clause, however. The amount of damages must be a genuine estimate of the loss that is likely to be suffered, as it will be considered a penalty if the rate is too high, thus potentially being deemed as unenforceable. The clause must also be reasonable in the circumstances, as this too could render the clause unenforceable.
Some examples of liquidated damages clauses include a clause that dictates a contractor must pay £100 for each day they are late completing a project or a tenant must pay a day’s worth of rent for each day they are late vacating a premises, to make up for the potential losses that a party could be making from a new tenant. The case of Cavendish Square Holding BV v Talal El Makdessi (2015) clarified that a clause should be upheld if it serves a legitimate commercial purpose and isn’t extravagant or unreasonable.
Some key differences between penalty clauses and liquidated damages clauses are that penalty clauses are usually designed to deter parties from breaching a contract to begin with, while liquidated damages clauses are intended to compensate the non-breaching party for any potential losses. The amount of damages specified in penalty clauses are not always genuine pre-estimates of the loss likely to be suffered, whereas the damages specified in a liquidated damages clause must be a genuine pre-estimate if it is to be enforceable.
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Understanding the distinctions between penalty clauses and liquidated damages clauses is essential when drafting, reviewing and signing contracts. While penalty clauses are generally discouraged, liquidated damages clauses provide a more legitimate way to protect the interests of the parties involved. Expert advice is invaluable when it comes to this topic, so if you’re in need of assistance, don’t hesitate to contact our team.