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• A brief guide to Liquidated Damages

Introduction

A liquidated damages clause specifies the amount of money payable in the event of a breach of contract. It enables each party to calculate the extent of their potential liability and to factor this into commercial decisions including for example, the price for the goods or services and the allocation of insurance.

What is a Liquidated Damages provision in a contract?

The general rule is that the figures provided for in the clause must be a genuine pre-estimate of the loss which would be brought on by the breach. If this is achieved the clause will be found to be enforceable by the courts. If it is not, the clause will be a penalty clause and therefore unenforceable.

The key message here is that the liquidated damages provision must not punish the party in breach, rather it should reflect the actual loss that the injured party would suffer. Whether or not the clause is a penalty will be assessed on the basis of what the parties could have contemplated at the time of the formation of the contract and not at the date of breach.

How do you select an appropriate figure?

The temptation is sometimes to select a figure which you think is "fair" having regard to your commercial situation without giving it too much thought. However, a case involving an hire purchase agreement[1] illustrates the need to take this a step further and actually do the sums.

The case involved a hire purchase arrangement for an Audi two-door coupe motor car from Volkswagen Financial Services (UK) Ltd ("VW"). The hirer fell into arrears and the vehicle was recovered by VW. VW then sought to recover all unpaid rentals, recovery charges and future rentals on the basis of the terms of the hire agreement. It is the latter category that was contended by the hirer. The hirer's argument was that the sum for future rentals was a penalty and therefore unenforceable. The court agreed on the basis that the clause did not take account of the fact that VW received the car back much earlier than it would have done had the contract run its term, which meant that it was more valuable due to the lower mileage and lesser depreciation.

In the case, the judge made the point that where a party wishes to use this sort of clause in a contract, they need to carry out some form of calculation to see what loss there might be if it were calculated on common law principles (i.e. damages so as to compensate the injured party for the loss which he has suffered as a result of the other party's breach of contract). Otherwise, it is impossible to establish that the liquidated damages clause is a genuine pre-estimate of loss.

Summary

Liquidated damages are commonly used in all sorts of agreements and are popular with both buyer and seller or supplier and customer. For the recipient of goods or services they can provide a deterrent to breach and reinforce contractual obligations. On the other side of the coin, the non-defaulting party may be able to recover damages without having to go to the expense of establishing actual damage.

If you are considering inserting a liquidated damages clause into your contract, you should remember the following points:

• calculate the actual loss that could arise as a result of one party's breach of contract;

• reflect those calculations in your liquidated damages clause;

• retain evidence indicating how the pre-determined sum was calculated (i.e. your sums);

• where you negotiated the figures used in the liquidated damages clause with your opposite number keep a record of your discussions; and

• remember that the clause must be a genuine pre-estimate of loss if it is to be enforceable.