Commercial Law Firm

Liquidated damages - enforceable or not ?

Liquidated damages clauses allow the parties to a contract to control the amount of damages that will be payable on the occurrence of a future breach of contract.

A liquidated damages clause, however, providing for the payment of excessive damages will be interpreted as a penalty, and will be struck out as unenforceable. Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] EWHC 281 (TCC) and the unreported case of Volkswagen Financial Services (UK) Ltd v Ramage (unreported, Cambridge County Court, 9 May 2007) illustrate recent judicial interpretation on the difference between, and construction of, liquidated damages clauses and penalty clauses.

The cases demonstrate that in a commercial context the presumption is that a liquidated damages clause will be upheld. Clauses based on sensible criteria are likely to survive judicial scrutiny, even where the damage actually suffered proves to be less than the compensation payable. That said, it is clear that the onus is on the person who wishes to assert that a clause is not penal to show how it was arrived at. The prevailing circumstances at the time of the contract are therefore relevant factors to be considered.

Liquidated damages clauses

What is their purpose?
Parties incorporate liquidated damages clauses into contracts for a number of reasons:

  • The main reason is often certainty. At the time of contracting, it is generally difficult to predict the amount of damages arising from a breach. It is therefore attractive to parties to know at the outset exactly what money they will have to pay or will receive upon breach of specific term.

  • The non-defaulting party benefits from making a recovery of damages without the difficulty and expense of proving actual damage. Legal costs are reduced and recovery of compensation made more efficient. Difficult legal disputes as to whether particular losses are recoverable are often avoided, reducing the risk of not being compensated for a breach of contract.

  • A liquidated damages clause reinforces contractual obligations and provides added deterrent to breach.

When will a liquidated damages clause be enforceable?
A court will uphold a liquidated damages clause if satisfied that the predetermined sum was a reasonable estimate of the probable loss following breach. The courts will generally look to uphold liquidated damages clauses in commercial contracts, given the clear benefits that they provide to both parties.

When will they be deemed unenforceable?
A liquidated damages clause is likely to be unenforceable as a penalty if:

  • the pre-determined sum is considered to be an unreasonable estimate of the probable loss, or

  • it has been used by one party to impose pressure or oppression on the other (which could be said to be another way of expressing the unreasonable nature of the predetermined sum).

The cornerstone of law

The distinction between liquidated damages and penalty clauses has been debated extensively. Fundamentally, the dividing line falls between whether the clause is a reasonable pre-estimate or intimidating over-estimate

The leading case is Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79. It set down four guidelines:

1. The name of the clause in the contract is not conclusive. A court will look beyond the clause's title and at its substance. Is the clause a reasonable pre-estimate of the likely loss following a breach? Or, does it instead constitute undue pressure on one party to perform its side of the contract?

2. The essence of a penalty is a payment of money that intimidates the offending party. This is compared with the essence of liquidated damages being a genuine pre-estimate of damage.

3. The question of whether a predetermined sum is or is not a penalty is a question of construction: in construing the clause a court will consider all the facts surrounding the negotiations at the time the contract was entered into, not at the time of the breach.

4. In construing the clause, the following tests are suggested:

4.1 a clause will be a penalty if the predetermined sum is extravagant and unconscionable in comparison with the greatest loss which could conceivably be proved to have followed from the breach

4.2 a clause will be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is greater than that which ought to have been paid

4.3 a clause will be presumed a penalty when a lump sum is said to be payable by way of compensation for a number of breaches, some of which may occasion serious damage and others not so serious damage, and

4.4 a clause will not necessarily be a penalty where a precise pre-estimation of the predetermined sum is impossible.

Analysis of the recent case law

McAlpine v Tilebox

The facts
Tilebox purchased a substantial commercial property with the intention of stripping it to its core and refurbishing it. Under its funding arrangements, Tilebox was to receive a development completion payment and a management fee. The development completion payment was calculated in accordance with a complicated contractual formula. Critically, one factor was delay in completion of the project. The development completion payment due to Tilebox from its funders would be progressively reduced if completion was delayed.

On completion of its funding arrangements, Tilebox entered into a building contract with McAlpine. This contract contained a liquidated damages clause providing for £45,000 per week to be paid by McAlpine to Tilebox in the event of delay in completion. This figure, which was accepted by McAlpine following negotiations, was the minimum weekly rental value of the completed building.

Completion of the building works under the contract between Tilebox and McAlpine was delayed significantly. To protect its position, McAlpine applied for a declaration that the liquidated damages clause was unenforceable as a penalty.

Tilebox argued that the rate of damages was a reasonable preestimate of damages at the time the contract was entered into. Tilebox pointed to the erosion of the development completion payment it would receive and its potential liability in damages to its funder for late completion.

Observations drawn on previous authorities

In considering the case law, Jackson J made four observations:

First he noted that two strands could be extracted from the authorities:
" some cases judges consider whether there is an unconscionable or extravagant disproportion between the damages stipulated in the contract and the true amount of damages likely to be suffered. In other cases the courts consider whether the level of damages stipulated was reasonable."He concluded that, in his view, a pre-estimate of damages did not have to be right to be reasonable. There had to be a substantial discrepancy between the level of damages stipulated and the level of damages likely to be suffered before the amount stipulated would become unreasonable.

Secondly, he stated that:

"...although many authorities use or echo the phrase 'genuine pre-estimate', the test does not turn upon the genuineness or honesty of the party or parties who made the pre-estimate."
Jackson J said that the test is objective, although the court should have some regard to the thought processes of the parties at the time they entered into the contract.

Thirdly, Jackson J recognised the anomaly within the law of contract that the unenforceability of penalty clauses meant that courts would not be giving effect to a clause that had been agreed in commercial circumstances by parties of equal bargaining power. Therefore, to counteract the anomaly, he said that a court should be predisposed to uphold contractual terms which fix the level of damages for breach, particularly where parties are of equal bargaining power.

Fourthly, the judge noted that the authorities contained only four commercial cases where a liquidated damages clause was struck down as a penalty, and:

"... in each of these four cases there was, in fact, a very wide gulf between (a) the level of damages likely to be suffered and (b) the level of damages stipulated in the contract"

Application of those observations

Taking these factors into consideration, Jackson J found in favour of Tilebox. At the time of contracting, Tilebox's weekly foreseeable losses arising from delay were greater than £45,000 a week. The figure was therefore a reasonable, and conservative, pre-estimate of damage.

The assessment of the foreseeable losses at the time of contracting was dependent on the finding that Tilebox had a liability to its funder for losses arising from delay. The judge acknowledged that weekly foreseeable losses would have been less if he was wrong on this point. That did not change the position. The pre-estimate of toss was reasonable, taking into account the reduction in the development completion payment. A pre-estimate does not become a penalty simply because it exceeds the actual loss suffered. A substantial disparity is required.

The judge drew support from the fact that the amount of liquidated damages had survived scrutiny by both parties during contractual negotiations.

Volkswagen Financial Services (UK) Ltd v Ramage

The facts

George Ramage hired a car from VW for a fixed period of 36 months under a hire agreement, agreeing to pay a set amount per month but also agreeing that, upon any repudiation, he would be liable to pay the total amount of rentals payable during the total hiring period, less the amount of rentals paid or due, less a rebate on the rentals not yet due. The relevant part of cl 8.2 provided that the hirer had to pay:

" compensation or agreed damages on acceptance of [the hirer's] repudiation, or a debt on our termination, the total amount of rentals payable during the Hiring Period... less the amount of rentals paid or which have become due."

When Ramage fell into arrears, VW notified him that his non-payment showed an intention not to be bound by the agreement and that he had therefore repudiated it, and that VW accepted his repudiation. VW recovered the car and sued for £13,365, comprising the amounts which it said were outstanding under the agreement: arrears of rentals to date of termination, recovery fee and what Judge Sennitt termed "a sum expressed to be future rentals-amounting to £10,428".

At trial before District Judge Pearl, it was accepted that, for clause 8.2 to be enforceable, it had to provide for payment of a sum that was a genuine pre-estimate of the loss that VW was likely to suffer as a result of Ramage's breach and, if it did not so provide, that it was unenforceable as a penalty. Ramage submitted that clause 8.2 was indeed penal and unenforceable.

The judge rejected Ramage's argument, finding that clause 8.2 was a liquidated damages clause and that this was a case where just such a clause was appropriate, since the calculation of VW's loss on early recovery was not an easy exercise given that VW would have to take into account variable factors such as a vehicle's mileage and condition, and even matters such as its make and colour, which might affect value. She further held that the court should be slow to strike out as penalties terms that were freely agreed and observed that she had found Ramage an articulate, intelligent man who had contracted in a free market without oppression to enter into the hire agreement. Ramage appealed.

Allowing Ramage's appeal, Judge Sennitt held that clause 8.2 did not provide for a genuine pre-estimate of loss, was in fact a penalty and therefore unenforceable. He found that Ramage was liable for the unpaid rentals and recovery charges element of VW's claim but not for compensation or damages for his repudiation.

Clause 8.2 was held to be penal because:

• It provided for payment of the entirety of the future rental payments but took no account of the fact that the car had considerably greater value as the result of being returned at that earlier stage rather than at the end of the three years.
• It was unfair that clause 8.2 required payment in effect of 100% of the hire payments— subject to the rebate—and did not take the residual value of the car into account, which it should have if it was to be interpreted as VW suggested.

In hire contracts, the general principle remained the same whether or not the chattel's capital cost/value was written off over the period of the hire; however, when it came to considering whether a liquidated damages clause was a genuine pre-estimate of loss, one had to take into account this additional factor if that chattel was intended to be returned at the end of the hire period and would still have had value at that time.

The owner had undertaken no prior exercise to calculate what loss it might suffer calculated on common law principles. As such, it could not show that the contract was intended to contain a genuine pre-estimate and had always approached the clause as having the effect of a penalty.

McAlpine v Tilebox emphasises that a court will be slow to interfere with a liquidated damages clause negotiated at arm's length between commercial parties. Such clauses have a commercial benefit to both parties. In particular, the court will not be impressed by arguments that the actual loss suffered is less than the estimated damages, unless the discrepancy is so large that it demonstrates that the sum could not have been a genuine pre-estimate of the likely loss.

Liquidated damages based on sensible criteria (in that case the likely weekly rental value of the property) are unlikely to be unenforceable as a penalty. Attempts to use such clauses purely as a deterrent to breach will be penalised by the courts and should be avoided.

Volkswagen Financial Services (UK) Ltd v Ramage illustrates that the onus is on the person who wishes to assert that a clause is not penal to show how it was arrived at. Further, undue emphasis should not be attached to the challenging party being an articulate, intelligent person who did not have to enter into the contract as it was found that such a person was equally entitled to rely on the fact that a provision in an agreement was a penalty if it did not represent a genuine pre-estimate of loss.

Liquidated damages clauses should always be calculated to reflect, as closely as possible, the loss likely to be suffered taking in to account the facts of each situation on an individual basis. There should be no standard formula that is applied time after time - the rate should be specific to each contract. Evidence should be retained whenever possible showing how the liquidated damages figure was agreed and calculated including details of any negotiation involved to show both the fact that the liquidated damage figure was a genuine attempt to pre estimate loss (as anticipated at the time the contract was entered into) and the nature and extent of negotiations to prove that a commercial agreement was reached.

Whether the courts would be slow to interfere in respect of a liquidated damages clause unilaterally (not negotiated) inserted by a large commercial organisation into a contract with a consumer is unclear. It appears that this is a one relevant factor considered by the Australian Courts when examining this issue:

“[t]here is, in my view,, a qualitative difference of which the law is able to take into account between a clause freely negotiated between a major commercial organisation, in respect of a substantial contract, where the major commercial organisation have available and receive competent legal advice regarding the meaning, purpose and likely consequence of the clause, from a clause attacked in a contract of adhesion between a major organisation and a individual or small company who has, in reality, no opportunity to negotiate the contract”*
“[t]hat is not to say that the latter form of contract containing such a clause would be struck down; it is rather to recognise that, quite apart from whether the clause fails because it lacks a compensatory character, it may also fail because a being imposed in the circumstances rendering enforcement of the clause unconscionable. The degree of contractual freedom afforded to parties to determine a measure of damages departing from strict compensation will, in my view, be affected by those matters constituting aspects of the relationship …”

* Cole J in Multiplex Constructions Pty Ltd v. Abgarus Pty Ltd (1992) 33 NSWLR 504

From the above, it may be the background relationship between the contracting parties (i.e. their relative bargaining position and whether or not there was an opportunity to negotiate a term) could possibly be one of the factors considered by the courts in determining whether a sum is a penalty or not. However, this is not clear and it may be that this is not considered by the courts at all. However, if it is, then it is likely that an individual consumer may be viewed more favourably by the courts than a large company.

In the event of a challenge, the burden is on the party liable for the damages to establish that the specified sum is excessive in the context of the likely losses which could be suffered. Should he be successful the party imposing the charge will have to bring a claim and prove his actual losses (or un-liquidated damages) instead of recovering the liquidated damages figure contained in the contract.

Liquidated damages are an essential part of many contracts and should not be viewed lightly. The effort involved in getting them right upfront far outweighs the damaging implications of getting them wrong and will always prove worthwhile.

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