Liquidated damages – recent developments in the case law

Liquidated damages (LD) clauses are often included in certain categories of commercial contracts as a remedy for breach, and their use is becoming more widespread following the Supreme Court joint judgment in Cavendish Square Holding BV v Talal El Makdessi (El Makdessi) and ParkingEye Ltd v Beavis [2015] UKSC 67 (ParkingEye), which we reported on here. Although a LD clause can be a useful remedy, it should only be used after careful consideration to avoid unintended consequences.

The recent case of Buckingham Group v Peel sheds some further light on the court's interpretation of LD clauses and provides an opportunity for consideration of a few key decisions in this area.

What is a LD clause?

A LD clause sets out amount of money contractually agreed by the parties to be payable as damages for a loss caused by a breach of contract, irrespective of what loss may actually be suffered by the innocent party.

Benefits of a LD clause

The Supreme Court set out some of the key commercial reasons for including a LD clause in Triple Point, Inc v PTT Public Company Limited [2021] UKSC 29.

In short, there are two key advantages to including a LD clause in a commercial agreement:

1. Firstly, a LD clause allows the non-breaching party to avoid a costly and lengthy dispute – the issues of evidence, heads of loss and mitigation do not arise for LD.
2. Secondly, while providing certainty to the non-breaching party in respect of the compensation that it is entitled to, LD can also limit the breaching party's exposure to liability, thus serving as a mutually beneficial risk managing provision.

Areas of concern

LD clauses are open to various challenges. Below we consider some of these challenges. However, although these cases provide some insight on the approaches taken by the courts, it is important to remember that when considering LD, the specifics of the drafting of the particular clause and the contract as a whole are pertinent.

1.  Penalties  

A LD clause will not be enforceable if it is a penalty. The original test to determine if a clause is a penalty was established in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79: a "genuine pre-estimate of loss" arising out of a breach is not a penalty and is enforceable. While still relevant for simple and straightforward clauses, the narrowly applied Dunlop test was re-formulated by the Supreme Court in El Makdessi, as follows: "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 [32]". The new test is two-fold – the court will determine: (1) if the clause seeks to protect a legitimate interest of an innocent party; and (2) if the remedy is proportionate to that legitimate interest.

It is worth noting that the penalty rule only operates on, and regulates against, the breaches of "primary obligations". If an obligation to pay can be expressed as a primary obligation which is not triggered by a breach of contract, this may circumvent the application of the penalty rule, although if a cleverly worded primary obligation is really a penalty in disguise, the courts may not uphold this exemption (as discussed in Heritage Travel and Tourism Ltd v Windhorst). The risk of a clause being challenged as a penalty may also be mitigated by fixing the amount of LD to the seriousness of the breach. Case law suggests that the threshold for claimants to satisfy the El Makdessi test is high.

2.  Uncertainty

LD may also be challenged on the ground of uncertainty. Careful drafting may help to mitigate this risk. When drafting a LD clause, the parties should consider the start and end date for the LD, the need to pro-rata the LD, different rates of the LD applicable for different breaches, the method and timeline for payment, how termination of the contract affects LD and if the LD are inside or outside any general limitation of liability provisions etc.

The recent High Court decisions provide a degree of comfort to the parties seeking to rely on a LD clause. The High Court was reluctant to hold a contractual provision void for uncertainty where it could find an interpretation which gave effect to the parties’ intentions (Eco World – Ballymore Embassy Gardens Co Ltd v Dobler UK Ltd [2021] EWHV 2207 (TCC); Buckingham Group Contracting Ltd v Peel L&P Investments and Property Ltd [2022] EWHC 1842 (TCC)).

3.  Cap on damages

A LD clause may be construed as an exclusive remedy for a breach and may prevent the claimant from seeking general damages in the alternative (which could be higher depending on the facts). Whether or not the LD clause is an exclusive remedy will depend on the construction of the particular clause and the agreement as a whole.

Even when it is unenforceable, caution should be taken with a LD clause as it may have the effect of limiting the breaching party's liability in a claim for general damages.

There is no set authority on this issue. In Eco World, obiter, the High Court found that, should the LD clause have been unenforceable, the objective understanding of the parties in the commercial context of the contract indicated their intention to limit the contractor's liability for general damages.

In the recent case of Buckingham Group v Peel, obiter, the High Court came to a different conclusion. On the facts, the court found that, should the LD clause have been unenforceable, it would not have capped the liability for general damages for the following reasons:

• the language of the clause was clear, it focused on the expression "cap on maximum LADs";
• the clause was located in the schedule that was specifically dedicated to LD and did not address the liability for general damages;
• the LD rates and the cap were both expressed as a percentage from the sum of the contract. This led the court to believe that they form part of a "single scheme".

4.  The "Red Hand" Principle

The case of Blu-Sky Solutions Ltd v Be Caring Ltd highlights the risk of using a LD clause in standard terms. A LD clause is likely to be deemed as an onerous term of a contract and it must therefore be validly incorporated in order to be enforceable. Therefore, using a LD clause in standard terms and conditions, which are unlikely to be negotiated/negotiable, or even countersigned, comes with a health warning on its potential enforceability.

Final thoughts  

Liquidated damages are a commercially attractive mechanism for the parties to agree remedies and their exposure to liability. At the same time, a poorly drafted LD clause may lead to substantial litigation risks.

The case law on LD is not definitive (or always consistent) but the recent case of Buckingham v Peel does provide some comfort where LD will not be determined to be a cap on liability.

Ultimately, the outcomes of disputes in relation to a LD clause are highly dependent on the drafting of the particular clause and contract as a whole. It is therefore very important that parties carefully consider the drafting of a LD clause – for example, the wording should state whether LD are an exclusive remedy and if any exceptions apply, as well as which breaches are subject to LD and which breaches are subject to a general damages claim. Parties should also ensure that other provisions in the contract do not conflict with the LD clause.

It is also always worth considering whether LD are the most appropriate remedy. While they have their benefits, for some breaches (particularly where there could be a wide range in the losses/damage depending on the severity of the breach) relying instead on other contractual remedies, such as indemnities, may be more suitable. 

If you would like more information on this topic, please contact Gordon Drakes.