When you’re signing a commercial contract with a partner, you may find it includes a penalty clause. Or possibly you’ve included one in a contract you’ve drawn up. This is, in essence, a clause which states that a specific sum is payable in the event of a specific failure, such as late delivery of materials or services, or late payment of an invoice.
Liquidated and Unliquidated Damages
Penalty clauses have a contentious legal status that largely depends on whether the sum is seen as liquidated damages (i.e. seen as proportionate compensation for the failure) or unliquidated damages, which are arbitrary and not necessarily proportionate.
Liquidated damages are arranged by means of a clause in the contract that specifies the extent of each party’s liability in the case of a default. Defaults may include circumstances such as late delivery of materials or delay in payment. To qualify as liquidated damages, it’s essential that the loss should be quantified and the damages should be proportional to that loss.
Unliquidated damages, on the other hand, impose a specific penalty on one or another party if a particular event occurs. This event may or may not involve financial loss, but what distinguishes unliquidated damages from liquidated damages is that the amount payable doesn’t depend on those losses. This makes the payment a penalty, rather than compensation.
Penalty Clauses and the Law
English common law, unlike some other legal jurisdictions, doesn’t recognise punitive damages, which means that, in general, a clause specifying unliquidated damages would be ruled invalid by a court. Traditionally, courts have tended not to recognise clauses that are seen as imposing a penalty, rather than agreeing compensation.
The standard position can be exemplified by a 1915 case in which a penalty was described as an “extravagant and unconscionable” deterrent. Recent cases, however, have shown a change in thinking in certain circumstances. Two cases, exactly a hundred years later, established the crucial test of whether the obligation breached was primary or secondary.
Primary and Secondary Obligations
A primary obligation is a stand-alone contractual obligation, e.g. delivery of specified materials, whereas a secondary obligation is an incidental extra, e.g. payment of damages in the case of non-delivery. The new cases have established the principle that, while damages for a primary obligation must be liquidated, in certain circumstances unliquidated damages can be applied to a secondary obligation
This means, for example, that any damages specified in the contract for failure to deliver the materials must still be calculated according to the loss you incur. However, if your partner then fails to pay these damages, a more arbitrary penalty may be imposed, providing it’s not seen to be entirely out of proportion to your legitimate interests.
Where Does This Leave You?
So where does this leave penalty clauses that you either wish to impose or are considering signing? Essentially, it’s a complex legal issue, and you’d be well advised to seek expert legal advice. On the other hand, if you’re convinced the clause is valid and the other party isn’t paying, you’re very welcome to give me a call to discuss your options.