A liquidated damages claim is a claim for an exact sum of money.
The amount can be calculated from the terms of the contract itself: it’s ascertainable from the terms of the contract. It could be said damages are liquidated down to a precise sum of money.
That makes it a liquidated claim.
So, the amount is set when the contract is made and:
- is a specific amount or an amount which can be calculated; and
- is payable on a specified breach of contract.
The contract might say that in the event of a failure to deliver services by a specified date, that £65.00 is payable on a breach of some particular, or provide that £12.00 is payable for each day delivery is late from the date agreed. Either way, the claim has been liquidated down to a specific amount, which makes it a "liquidated claim".
It’s this pre-agreement which sometimes lead to claims of penalty clauses and relief from forfeiture by the contract breaker, to avoid the consequences of what was first agreed.
Liquidated Damages v Unliquidated Damages
If damages are not able to be ascertained from the words in the contract, damages:
- are said to be “at large”. The amount of damages which must be paid is unknown; and
- must be decided as part of a formal judicial process - an assessment of damages - after considering the evidence filed by the parties, and usually at a hearing.
The judge considers the evidence which has been filed, and after hearing submissions by the parties and fixes the amount of damages payable by the defendant.
In this way, an unliquidated damages claim is assessed down to a figure to determine the amount of money that must be paid by the contract breaker. More on the process and factors involved in an assessment of damages below.
Liquidated Damages Clauses
The terms of liquidated damages clauses are agreed by the parties at the time the contract, not after it is made. Parties are free to do so based on the fundamental principles of freedom of contract. Courts recognise the benefits of liquidated damages clauses. They're usually reluctant to interfere with them, because is an interference with the parties' freedom to contract on the terms that they choose.
Liquidated damages clauses provide:
- a fixed amount to the innocent party: whether the damage was suffered or not
- a defence to the party in breach for larger claims for damages.
The loss calculated by the clause does not actually need to arise for the liquidated amount to be paid. It’s the event of the breach of contract which gives rise to liability to pay under the clause.
Liquidated damages clauses don’t impose fines. They’re awards of damages: compensatory and not penal in nature.
Liquidated damages clauses are sometimes challenged after the event, when the contact breaker is in breach of contract and the innocent party calls on them to pay.
In order to be an unenforceable penalty, the liquidated damages clause impose a consequence which is oppressive upon the contract breaker: the consequences of the clause exceeds legitimate interests of the party seeking to enforce the terms of the clause.
When is a liquidated damages clause an Unenforceable Penalty?
The law relating to penalties comes into effect in limited circumstances:
It applies when:
- a provision in a contract operates upon a breach of contract, and
- that provision fixes an amount to pay compensation as damages.
When the law relating to penalties does apply, a two-step assessment process applies to assess its enforceability.
- Identification of the legitimate business interest - if any - is protected by the clause, and
- whether the provision made for that interest is extravagant, exorbitant or unconscionable.
That is, whether it’s oppressive.
The reference point for the extravagance is the “the highest level of damages that could possibly arise from the breach”. To ascertain where that reference point lies, an assessment of damages in the ordinary sense needs to take place.
The level of damages sought to be imposed by the clause must be out of all proportion to the innocent party’s legitimate interests to enforce the its contractual rights.
It used to be said that a liquidated damages clause which was not a “genuine pre-estimate of the loss” was not enforceable. That’s no longer the case. The law changed in two Supreme Court cases which were heard together, Cavendish Square Holding BV v Makdessi; ParkingEye Ltd v Barry Beavis  UKSC 67.
In those cases, it was said:
true test is whether the impugned provision is a secondary obligation which 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
The change in law means that a liquidated damages clause may be valid even if it is:
- not a genuine pre-estimate of the loss, or
- aimed at deterring a party from breaking the contract.
Secondary Obligations vs Primary Obligations
The place of the law of penalties is squarely on the consequences of a breach sought to be imposed by a breach of contract.
An assessment of primary obligations – what has been agreed by the parties for the purpose of performance of the contract – would lead to an intrusion by courts into an enquiry as to the commercial fairness of the terms agreed. This is territory where courts rarely go. When they do, it’s usually as a consequence of the existence of legislation, such as the Unfair Contract Terms Act or Consumer Rights Act.
What’s a primary obligation in a contract?
Examples: Primary Obligations
Types of primary obligations in contracts include:
- payment of an amount to exercise an option
- a condition precedent or a condition subsequent
- an obligation to pay a minimum amount under a contract which is a primary obligation
- setting a fee for services and then offering a discount for payment within a specified time period which is shorter than what would otherwise be required under the contract.
With primary obligations, the obligation does not arise from a breach of the contract. If an obligation to pay is penal, it must require payment as a result of the breach itself and is a secondary obligation.
Liquidated damages clauses deal with the consequence of breach of the primary obligations of a contract, which is the secondary obligation to pay damages.
When the clause is a primary obligation, the law of penalties does not come into it. Liquidated damages clauses impose a secondary obligation (to pay damages), not a primary obligation (to perform the contract).
The legitimate interests of the innocent party are quite limited.
A contracting party has a legitimate interest having the contract performed, or some alternative to that performance. That alternative usually requires payment of the amount of compensation in damages by the contract breaker for the financial loss suffered by the innocent party.
When a liquidated damages clause goes beyond that (and is extravagant, exorbitant or unconscionable in its nature and impact) it:
consists of the imposition of an additional or different liability upon breach of the contractual stipulation …
A motorist takes advantage of an offer to park in a carpark for free for a limited period of time.
The motorist overstays the free period. The contract for parking states that overstaying the free period, requires payment - to pay liquidated damages as a result.
The payment is enforceable provided it is not excessive, because the legitimate interests of the operator of the car park include being paid for the overstay, as well as the use allocated for the initial free period.
Enforceable Liquidated Damages Clauses
Liquidated damages clauses focus disputes when a party is in breach of contract.
They keep more disputes out of court, and if they do proceed to court, the issues in dispute are more likely to be limited. When arguments about penalties arise, it usually means that the defendant accepts it is in breach of contract, or provides for that outcome in its Defence.
Liquidated damages clauses are less likely to be considered penalties when:
- The clause fixes an amount somewhere within the range is likely to be acceptable by a court, by reference with an award for common law damages
- Financial loss arising from the breach is difficult to quantify
It is not a prerequisite that a pre-estimate of damages is correct to be reasonable. The fact that it may result in overpayment is not fatal. The innocent party is allowed a generous margin
Consistent with the principles of freedom of contract, businesses are usually considered the best judges of the contractual terms they accept. This includes the consequences of a breach of the contract should it arise.
When Liquidated Damages Clauses are Penalties
Liquidated Damages provisions which are penalties are not enforceable.
The effect of a penalty is to require a contract breaker to suffer a consequence which is out of all proportion to any legitimate interest the innocent party has in performance of the contract. Accordingly, a remedy in a contract which imposes a consequence which significantly exceeds the legitimate interest of a party is unenforceable.
It is then they that are unenforceable.
When they’re found to be unenforceable that’s not the end of the story.
The contract breaker is still required to pay damages. The unliquidated will be liquidated by the court as part of an assessment of damages.
The party in breach is not required to the pay the amount liquidated by the clause. They’re still required to actual the damages which in the fullness of time will be decided by a judge. It’s the court that liquidates the amount to be paid down to a specific sum, by assessing the loss the arriving at an award of damages.
In those cases, damages which are at large are decided as part of the assessment of damages. The losing party is more than likely to be required to pay the costs of the proceedings for the judge to decide the award.
Advantages of Liquidated Damages Clauses
Avoidance of Escalation of Disputes
- Exposure is known for liability for the specified breach, which remains subject to supervisory jurisdiction of courts
- L(iquidated and) A(ascertained) D(amages)s provisions take the good with the bad: the contract breaker has a defence to claims for a higher amount by the party not in breach of contract
- The parties are spared the cost of legal proceedings to arrive at the sum payable to compensate for the breach. This saves the parties time and money resolving the dispute.
Minimisation of Disputes
- Liquidated damages can provide a structured regime for compensation to be paid for non-performance for trivial breaches – or breaches not worth suing over or not cost effective to sue, such as in:
- IT services and outsourcing contracts, such as service level compensation for service failures and delays, such as:
- delivering contractual services as part of software-as-a-service, amongst others
- defects in software development projects
- construction contracts to compensate for delay, and/or
- any other type of contract where a fixed financial consequence for a breach is agreeable between the parties to avoid disputes escalating
- IT services and outsourcing contracts, such as service level compensation for service failures and delays, such as:
- Liquidated damages clauses better serve long running contracts of supply. Arguments about the amount of loss and acrimonious negotiations about the level of loss in any particular breach can be avoided
- The liquidated damages clause may not properly compensate for the particular breach. Damages could be significantly greater than the recoverable loss suffered by the party in an assessment of damages.
- Clauses are sometimes abused (knowingly or not) to extract greater amount than the likely actual loss
Relief against Forfeiture
A forfeiture is preceded by receipt of property – money, personal property or real estate is a precursor for security of performance.
If the contractual obligation is not fulfilled:
- the part in breach loses the possessory right or proprietary right, and
- a clause prevents the transferor from recovering the property previously transferred
For example, a deposit might be required to be paid to secure a purchase. When the buyer does not proceed with the purchase, the deposit is forfeited: they’re not entitled to get it back.
The law of forfeitures operates to entitle the payer or transferor of property to recover the assets from receiver of the property if a contract obligation is not honoured.
The law of forfeitures operates when the failure by the party in breach for non-performance imposes an unjustifiable detriment to on the party in breach for the benefit of the other.
When a forfeiture is in issue, courts look at the position of the contract breaker after the breach takes place, to assess whether the forfeiture should be allowed to stand. As time has run on the contract by the time the forfeiture has taken effect, the sounding circumstances are able to be taken into account.
Assessments of Damages in Contract Law
When liquidated damages are not in issue, the usual legal process in an assessment of damages is as follows:
After the claimant sues the defendant for enforcement of the liquidated damages clause, legal proceedings advance in two stages:
- Determination of liability
Before a defendant can be liable for damages at all, first they must be found to be in breach of contract.
Assuming the that a court finds that the defendant was in breach of contract, the court will progress to assess damages for the breach.
- Assessment of Damages
A series of legal principles apply to assessment of damages, which courts apply to arrive that the amount of damages which should be paid by the defendant for the breach of contract.
Liquidated damages are a form of predetermined loss, which means that the assessment of damages stage is intended to be avoided.
Liquidated damages clauses are included in contracts to avoid the complexities of the second stage. The breach is usually known to the parties. The breach either falls within the meaning of the defined breach or not.
The essence of a liquidated damages is that an amount is agreed and settled upon by the parties at the time of the contract. Each party pre-compromises what the loss will be and that is taken to be the amount payable in damages if the circumstances of the breach arises.
Penalties and forfeitures extend well beyond the detriment which would be recoverable by the innocent party: damages are compensatory, not penal in nature.
A liquidated damages clause is more likely to be unenforceable when the loss sought to be recovered is out of all proportion with the loss that would recoverable in the form of common law damages. That extends beyond the legitimate interests of the innocent party.
In some cases, the legitimate interests of a party are not limited limited to obtaining financial recompense: there could be more to the legitimate interests of the innocent party.
There are other factors taken into account in the assessment of the validity of liquidated damages clause by courts; not just those mentioned above.
Whether liquidated damages clauses are penalties is decided by reference to the terms at the time of the making of the contract, not as at the time of the breach.
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