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Liquidated Damages and Penalty Clauses: Where are we now?

11 Jul 2017

Construction law specialist, Jan Rzedzian, provides guidance on Liquidated Damages in construction contracts, highlighting the core principles from the case of Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited.

Liquidation damages clauses in Contracts continue to be a major source of disputes between parties to commercial Contracts. Within the Construction and Engineering sectors, in particular, the inclusion of liquidated damages as an Employer’s financial remedy for a Contractor’s delay in completing the works is well established and commonly included in both standard and bespoke forms of Contract.

Under English Law, the liquidated damages clause generally allows the contracting parties to pre-set the level of damages recoverable by the innocent party in the event of a specified breach by the party in default. The benefit of such a clause is that it is quicker and more commercially expedient for the innocent party to claim the agreed liquidated sum once the event occurs, rather than issue a claim for damages for the particular breach.

In addition, the innocent party simply needs to show that the relevant breach has occurred. They do not have to prove they have suffered any actual financial loss as a result of the breach, nor that they’re under a duty to mitigate loss, as would be the position where a claim for general damages is made. As a consequence, the amount recoverable will not be subject to the Court’s general discretion.

Historical Approach to Liquidated Damages

The key authority on liquidated damages remains the case of Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited (1915) AC79 which was decided over 100 years ago. The basis of the case is that a liquidated damages figure will be struck out as unenforceable if it is considered to be a penalty. Subsequent cases have elaborated and clarified the core principles laid down in the “Dunlop” case, which can briefly be summarised as follows:

  • The purpose of the liquidated damages clause is crucial. Its primary purpose must be to compensate the innocent party for any loss suffered as a result of the breach of Contract. If the intention of the clause is to apply undue force on a party to compel him to perform the Contract, it will be regarded as a penalty and consequently unenforceable.
  • The figure included in the clause must be a genuine pre-estimate of the anticipated financial loss which the innocent party would be likely to suffer in the event of a breach of the obligation in question. If the sum specified is “extravagant and unconscionable” when compared with the actual loss that would flow from the breach, the clause will be regarded as a penalty.
  • The determination of whether a sum is a penalty or a genuine pre-estimate of the loss must take into account factors at the time the Contract was made, and not those factors existing at the time of the breach.
  • It is assumed that a clause is a penalty if the same liquidated damages figure applies to all breaches of contract, however serious or minor.
  • The terminology or wording of the clause is largely irrelevant. It is for the Court to determine as a matter of fact whether the agreed amount is a penalty or a genuine pre-estimate of the loss.
  • If the breach is a failure to pay a sum of money (the principal sum) and the agreed liquidated damages figure is higher than the principal sum, the liquidated damages figure will be considered to be a penalty.

For further information, please contact Jan Rzedzian, Associate Solicitor in the Construction Team at Hay & Kilner

Call: 0191 232 8345

Email: Jan.Rzedzian@hay-kilner.co.uk