Ruth Mitchell

What's the Damage? How to use Liquidated Damages

With Watson Burton LLP Law FirmMany commercial contracts contain clauses that fix the amount of damages payable on breach of contract. These provisions are known as liquidated damages clauses. Should one party breach the contract they must pay the other party a specified sum of money.Liquidated damages clauses are generally enforceable provided the amount payable is a reasonable estimate of the probable loss following breach of the contract. The established authority in this area is Dunlop Pneumatic Tyre Co Ltd –v- New Garage & Motor Co Ltd [1915] AC 79. The House of Lords distinguished liquidated damages clauses (which are enforceable) from penalty clauses (which are unenforceable). It stated that that the essence of a penalty clause is a provision that intimidates the other side, whereas a liquidated damages clause provides a genuine pre-estimate of damage. The House of Lords stated that the issue of whether the predetermined sum is a penalty or not depends on the construction of the clause and the circumstances surrounding the agreement judged at the time of making the contract and not the breach itself. Further, it stated that the predetermined sum will be construed as a penalty if it is “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”.The onus of demonstrating that a clause is a penalty clause rests with the person seeking to avoid it. Generally, the courts will seek to uphold liquidated damages clauses in commercial contracts. Clauses that are viewed purely as a deterrent, however, will be interpreted as penalty clauses.Those businesses who draft and rely on liquidated damages clauses should take care to ensure that the clause cannot be interpreted as a threat or deterrent and that it represents a genuine pre-estimate of loss. It is sensible for business owners to keep accurate records of how the amount of damages was calculated and, where possible, evidence of negotiations of the figure with the other party. If you have any queries relating to this article, please contact David Hankin at Watson Burton LLP (david.hankin@watsonburton.com or 0191 244 4316).

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