Don't let the other side get a kick out of your penalty!

The essential purpose of a contract is to establish and regulate the obligations and entitlements of each party. Usually, this comes down to one party providing goods, or services, in return for some kind of payment by the other party.

Where a contract imposes obligations upon one of the parties to it, then at its simplest a breach of those obligations will place that party in breach of contract, with the resulting prospect of legal liability to the “innocent” party.

The general rule is that a breach of contract will entitle the “innocent” party to nominal damages; beyond that, if the innocent party can show actual loss resulting from the breach then damages may be claimed in respect of that loss, subject to certain restrictions and limitations.

Sometimes, however, the contract sets out what will be the consequences of particular breaches. At first glance, that may seem a good idea. Why incur the cost and hassle of having to prove the amount of your losses arising out of a breach of contract, if the contract instead could simply provide for a fixed amount or basis of calculation?

There may not necessarily be anything wrong with that. But, as ever, you should exercise extreme care when considering any such arrangement.

There are various reasons for that. But a principal difficulty is that a provision of that nature will only be enforceable if the compensation for which it provides can be classified as “liquidated damages”.

What that means is that the compensation must be a genuine attempt to pre-estimate the likely loss which would result from the breach in question.

If that cannot be shown to be the case then the provision is likely to be classed as a “penalty clause” and it will not be enforceable.

So, for example, if an agreement provides for A to pay B £1,000 on a particular date, and goes on to say that if it is not paid then there will be a £50 administration charge and interest will accrue at 3% over base, then that is likely to be upheld because it is a reasonable attempt to reflect the likely loss to B if A does not comply.

But if the provision says that if the £1,000 is not paid then the amount payable will immediately rise to £1,500, then unless there were to be particular circumstances by which B can show that that is likely to be the immediate consequence for him, it will not be enforceable because it will be considered to be a penalty clause – designed to punish A, rather than compensate B, for non-compliance.

Obviously that is a very simple example. The distinction can be less easy in more complex circumstances. In a recent case in the Commercial Court a supply contract imposed a minimum purchase obligation on the buyer. That is not unusual. But because of the consequences, as set out in that particular agreement, if the buyer did not purchase at least the minimum threshold, when the supplier tried to enforce it the clause was held to be unenforceable on the basis that it amounted to an unlawful penalty. In that situation it would have been better to draft the clause as a minimum payment obligation, rather than a minimum order requirement.

Of course each case turns upon its particular facts. But in difficult economic times it is particularly important to ensure as far as possible that the contracts on which your business relies for its turnover mean what you think they mean, and will take effect as you expect. Professional advice at the outset is generally a wise investment.

This bulletin is not intended to be comprehensive or to provide specific legal advice. It should not be relied upon in the absence of specific advice given in relation to particular circumstances.


For further information on this or any related topic please contact Philip Cuerden or Carina Sparkes.



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