Liquidated Damages: Where are we now?

What are liquidated damages?
A good starting point and the answer to which has not changed. Liquidated damages (sometimes also called liquidated and ascertained damages particularly in the construction and engineering industries), LADs or LDs for short, are contractual provisions which provide a remedy for a breach of contract by way of a pre-agreed entitlement to a level of damages. The fact that these damages are pre-agreed, whether by way of a fixed sum or the application of some calculation or other mechanism, means that the damages are ‘liquidated’ as against the ordinary damages remedy for a breach of contract where the damages are unliquidated or ‘general’ damages and the injured party will claim compensation based on the principle that they should be put in the same position as if the contract had been performed but with no prior agreement between the parties as to what that compensation should be.

A simple example of an LD provision is that a contractor will pay a customer £X for each day that the contractor is late in delivering the contract goods to the customer. Service credits under a Service Level Agreement are also a form of liquidated damages.

Liquidated damages do not need to be by way of a cash payment. The above LD provision might be structured so that, for example, for each day’s delay the contractor will (i) discount the price of the goods, or (ii) provide future free services, or even (iii) issue shares in the contractor at a fixed price below market value. The fact that an LD provision need not be a simple ‘cash payment’ provision means that a provision which describes certain financial consequences arising from a breach of contract may be a ‘disguised’ LD provision and care is needed to recognise such a provision and to structure it accordingly.

On the other hand, a contract provision which allows one party to terminate the contract if it makes a cash payment to the other party is not an LD provision. The payment is not made as a remedy for a breach of contract: the party has a free choice as to whether or not it wishes to terminate the contract and the provision simply states the contractual consequences if that right is exercised. The payment is not any form of compensatory damages.

Are liquidated damages provisions enforceable?
Perhaps surprisingly, this question also has a clear and consistent answer. An LD provision is enforceable unless the intention of the provision is to secure performance of the contract by the imposition of a fine or penalty which is exorbitant or unconscionable, in which case such a ‘penalty’ clause is unenforceable as a matter of public policy.

How do you know if you have an enforceable liquidated damages provision or an unenforceable penalty clause?
That is the crux of the matter and what the recent cases have been about. Two cases concerning LDs reached the Supreme Court and were joined together because they raised the same questions as to the distinction between LDs and penalties. (Makdessi –v- Cavendish Square Holdings and ParkingEye –v- Beavis (2015)).

The Supreme Court held that “the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract“.

Prior to this decision, the test had been, more or less, whether the LD’s represented ‘a genuine pre-estimate’ of the loss to the injured party arising from the breach, even if that estimate was at the ‘top end’ of any such estimate, or whether the amount involved went above and beyond that so that it was not any form of genuinely compensatory damage but was simply a punitive consequence of the breach i.e. a penalty.

What is an ‘interest’ in the performance of the contract?
In Makdessi/ParkingEye the Supreme Court said that the question is whether the relevant provision “imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”. So one first identifies whether the innocent party has a legitimate interest in enforcing the contractual performance of the other party (which seems unlikely to be answered in the negative in anything other than very unusual circumstances) and one then determines whether or not the financial consequence imposed on the other party for breaching that contractual obligation is exorbitant/unconscionable/out of all proportion to that legitimate interest.

Whilst the distinction may not always be obvious, this is in fact a new and different test from the traditional ‘genuine pre-estimate of loss’ approach. The facts in ParkingEye provide a good illustration.

In ParkingEye a driver overstayed the two-hour limit in a car park and received an £85 parking fine. The Court accepted that this fine may well be viewed, at least by THE car park users, as simply a deterrent against over-staying the two-hour limit and that the car park owner might not suffer any obvious loss as a result of the over-stay. But the Court also held that there were clear legitimate commercial interests that the owner wished to protect by imposing the charge, including managing the efficient use of parking spaces, deterring long-stay parking, and providing an income stream to run the car park and make a profit.  The charge was not “out of all proportion” to those interests, evidenced in part by the use of the car park by drivers who were aware of the over-staying fine, and so was not a penalty.

What is ‘out of proportion’ to an interest in enforcing the contract?
Two cases have considered this question since Makdessi/ParkingEye and have reached different conclusions.

In GPP Big Field –v- Solar EPC Solutions (2018), the LD provision imposed the same financial consequence for a breach of any one of several EPC contracts, although the consequence of such a breach for the injured party would be different depending on which EPC contract as affected. The Court appeared to accept the validity of this argument in support of the provision being a penalty clause, but ultimately concluded that it was an enforceable LD provision because (i) it had been negotiated between two commercial entities who were well able to understand the financial implications, (ii) such ‘one size fits all’ payments were not unusual for breaches of this nature (delays) in the construction industry, and (iii) the lack of gradation did not matter because the level of LDs was not “extravagant and unconscionable in amount in comparison with the greatest loss that might have been expected to follow from the breach when the contract was made.”

In Vivienne Westwood –v- Conduit Street Development (2017) Vivienne Westwood as the tenant had a lease accompanied by a side letter which provided for a reduced rent from that stated in the lease and also stated that if the tenant breached the lease then the side letter would terminate and the rent would revert to that stated in the lease. Conduit Street as the landlord argued that it had a legitimate interest in the tenant properly performing its obligations under the lease. But the Court rejected this argument; the tenant’s obligation was to pay the agreed reduced rent and the landlord could not argue that it had a legitimate interest in seeing the rent revert to the higher level – that would be a legitimate interest in the tenant’s non-performance and not in its performance of its obligations! Further, the consequential obligation to pay the higher rent was undoubtedly penal in nature because it was out of all proportion to the landlord’s legitimate interests under the lease and it applied regardless of the seriousness of the breach which occurred.

In our view it is difficult to reconcile Vivienne Westwood with Makdessi, ParkingEye and GPP Big Field, but Vivienne Westwood does show that the enforceability of LG provisions cannot be taken for granted and that proper drafting and consideration remains the order of the day.

Can liquidated damages be used to deter a breach of contract?
One interesting implication of the Supreme Court’s decision in Makdessi and ParkingEye is that LD’s can, apparently, be used to deter a breach of contract. Prior to this decision it was thought that LD’s had to be in the nature of compensatory damages, however calculated, and could not be structured simply as a deterrent against a breach of contract. However, it should be noted that a number of other ‘legitimate interests’ were cited in both of those cases and neither case relied solely upon the claimant’s legitimate interest in the deterrent effect. The Vivienne Westwood case also sounds a cautionary note in this respect.

Can you have your cake and eat it? Can you claim both liquidated damages and general damages in relation to the same breach of contract?
If an LD provision is enforceable then, as a matter of construction unless the contract provides to the contrary, the injured party cannot both recover the LDs and claim general damages in respect of the same breach. However, where an underlying breach of contract has a ‘knock-on’ effect, it is not unusual to see the general damages claim preserved. For example, service credits will ordinarily be expressed as the exclusive remedy for a service level failure, but where that service level failure arises as a result of an underlying contract breach, the right to claim general damages in respect of other consequences may be preserved.

If an LD provision is in fact held to be a penalty and hence unenforceable then the injured party may still then be able to claim general damages in the ordinary way, unless the unenforceable provision was held to be the injured party’s exclusive remedy.

So where are we now?
LD provisions should be drafted in the context of the legitimate interests of the party that they are intended to protect. Those interests can include acting as a deterrent against a breach of the contract, but we recommend that the deterrent effect is not relied on as the sole reason and that those interests listed are described as inclusive rather than comprehensive.

Where the breach of contract may give rise to different consequences for the injured party depending on the nature of the breach, a ‘one size fits all’ form of LD’s may be considered ‘out of proportion’ to some of those breaches and so more at risk of being declared an unenforceable penalty clause than LD’s which are bespoke or gradated in some manner.
Ideally the LDs should not be described as an exclusive remedy, although of course this may be a matter of negotiation between the parties.

Care should be taken to identify ‘disguised’ LD provisions, such as service credits and other financial consequences of breach, and to frame them in the same ‘legitimate interests’ context as a cash payment.

Be aware that the ‘tipping point’ from enforceable liquidated damages to an unenforceable penalty is still, in effect, a financial assessment. Whilst in ParkingEye the Court upheld the £85 fine, the point at which the level of such a fine would be ‘exorbitant’ and an unenforceable penalty is still a question for the Courts.