Liquidated Damages v Penalty
The parties to a contract may pre-agree the level of damages or compensation, payable in the event of a breach. Pre-agreed damages are described as liquidated damages. It is a basic principle that pre-agreed liquidated damages must not amount to a penalty. They must compensate only and may not be pitched at such a level that they are penal or coercive.
A sum of money which a contract provides is to be paid in the event of a particular breach or other circumstance may be classified either as liquidated damages or as a penalty. Liquidated damages are valid. The label is not definitive. Whether the sum is or is not a penalty is a matter of substance in the circumstances.
Generally, civil law prohibits private penalties. Damages are compensatory. The civil law may not be employed as a method of punishing or for enforcing private bargains where no actual loss is entailed. Apart from the principle that the State will not lend itself to private policing, the upholding of penalties may lead to economically inefficient transactions.
A penalty need not necessarily be limited to the payment of a fixed sum of money. If the contract provides for any other obligation upon breach, that is disproportionate to the loss caused by the breach, it will be a penalty and accordingly, it will be unenforceable.
If the sum payable is greater than the price (or another sum) payable under contract itself then, the sum is presumptively a penalty.
Liquidated damages are valid if they are a genuine pre-estimate of the loss that may be suffered. In contrast, penalties are held to be “in terrorem” i.e. as a threat by way of sanction or force. If the intention is to apply a penalty, the courts will not apply the clause and it will be unenforceable.
A sum pre-agreed that is extravagant, unconscionable and out of proportion to any genuine pre-estimate of loss is a penalty. However, provided that the sum payable is not extravagant, having regard to the range of loss that could reasonably be anticipated, it may be accepted as a genuine pre-estimate of loss, and accordingly as valid liquidated damages.
Once the liquidated damages sum is valid at the outset in accordance with the above criteria, it will apply irrespective of the actual loss. Mitigation does not arise. The proof of actual loss or damage is not required. The agreed liquidated damages will apply, even where the amount stipulated is significantly less than, or more than, the actual loss.
At common law, certain types of penalty bonds were accepted. The courts of equity generally refused to enforce penalties. However, the modern law is that penalties are void in equity and at law.
Distinguishing Liquidated Damages and Penalty I
There are a number of criteria used by the courts to distinguish between liquidated damages and penalties. The use of the words penalty or liquidated damages, although relevant are far from conclusive. A sum labelled as one or the other, may in substance be the other. However, the label may be significant in indicating the intent of the parties.
The courts look at the circumstances as a whole, to determine whether a stipulated sum amounts to liquidated damages or a penalty. The position is judged as at the time of the making of the contract. A sum is a penalty if it is extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to follow from the breach.
If the nature of loss is such that the sum can be reasonably calculated at the time of the contract, then the fixing of a larger sum is presumptively a penalty. Where the sum cannot be reasonably calculated at that time, it is less easy to categorise it as extravagant or unconscionable.
Distinguishing Liquidated Damages and Penalty II
A distinction is made between cases where there is only one circumstance or obligation, on the breach of which, the sum becomes payable and cases where there are several circumstances and obligations, any of which trigger the liquidated damages compensation. In the latter case, the test whether the measure of liquidated damages is extravagant or unconscionable relative to the greatest possible loss.
If the loss to the claimant may arise from one of a number of breaches, which can be accurately calculated in monetary terms, the fixing of a larger sum is presumed to be a penalty if it applies to all possible breaches. It is immaterial that some of the breaches were not determinable or would involve a greater loss and even that one such event has in fact in fact occurred.
Where the loss is not reasonably calculable in monetary terms, it is less likely to be classified as a penalty. The variety of possible losses does not preclude a valid provision for liquidated damages if the court can hold that the probable loss following is equally uncertain in each case or can be averaged out over a number of cases.
Saved by Interpretation
The obligation to pay or take liquidated damages does not apply, to the extent that the contract on its true interpretation, provides for other breaches, to which the liquidated damages clause does not apply. In this case, breaches outside the scope of the clause may be the subject of a claim for damages.
Where as a matter of interpretation the damages clause is applicable only to more serious breaches, rather than indiscriminately, then it may be saved from being categorised as a penalty.
However, the court may not artificially break down contractual obligations which are in substance a single whole, into a number of obligations of varying importance so as to treat the liquidated sum as a penalty because some of the individual breaches do not cause loss or injury, which is commensurate with that sum.
Disproportionate Payments likely to be Penalty
There is a greater chance of the sum being categorised as a penalty if the various breaches which trigger its payment are indiscriminate. In this case, the strength of the chain may be tested by its weakest link.
If the same payment arises on the breach of any of a number of obligations, it is more difficult to uphold the obligation as liquidated damages. There is a presumption that a sum is a penalty where a single lump sum is made payable by way of compensation on the occurrence of one or more events, some of which may occasion serious loss damages and others trifling loss and damages.
Minimum payment obligations are particularly vulnerable to being void. However minimum payments have been held to be reasonable in many contexts, where there is a rational relationship between the breach and the loss. Provided that they are framed reasonably and do not act arbitrarily, they may be upheld
Proportionate Payments less likely to be Penalty
If different sums are stipulated for different breaches, or where the sum accrues proportionately, as in the case of breach by delay, there is less risk that they will be deemed a penalty.
Liquidated damages for delay often accrue on each day or week on which the breach continues. Most building contracts provide for a sum payable for each day of late delivery.
The classic instance of liquidated damages is those which apply on late completion of buildings or other major infrastructure projects. They are usually a set sum per day or per week of delay. They are generally acceptable in principle as valid, provided that rate is not disproportionate in accordance with the above criteria.
In the employment context, lump sum payments may arise under the contract in a number of contexts. They may, or may not, be a penalty depending on context. Pay in lieu of notice, on the employer’s side is generally acceptable. There have been cases in which obligations on an employee to pay damages in lieu of notice, have been held void as a penalty.
Where a person has undergone training and he fails to remain in employment for a particular period afterwards, he may be obliged by his contract to repay part of the training cost. In some cases, this is accepted as a valid liquidated sum, while in others where it exceeds the loss and cost to the employer, it has been held to be void as a penalty.
In the employment context, contracts in restraint of trade between the buyer and seller of a business or in much narrower circumstances, between an employer and employee, may be upheld provided, that they are reasonable.
If a person breaches a restraint of trade covenant and becomes liable to pay a lump sum, the obligation may be upheld as liquidated damages on the basis that it is difficult to pre-quantify the loss.
Where the liquidated sum payable on breach of a hiring agreement is reasonable in accordance with the above criteria, it is valid. Each case depends on its own circumstances. Where the hirer was obliged to pay the owner, all rent due and a further 50 percent, the clause was upheld. It was sufficiently equivalent to the actual loss likely to be occasioned by the hirer in the event of a breach.
Traditionally, hire purchase contracts provided that on a hiree’s default in paying instalments, the owner might retake the goods and claim a liquidated sum to cover depreciation. Originally, the courts held that the principle of liquidated damages did not apply. However, this approach was questionable and was quickly overruled by legislation.
Many clauses in hire purchase agreements which provide for minimum payments on the breach have been held to be valid. In some such cases, depreciation was accelerated and the sum due on default for payment by the hiree was significant.
Hire Purchase legislation, now in the Consumer Credit Act, severely limits the extent to which the hirer can determine the contract and charge liquidated sums to the hiree. Most of the statutory intervention applies to consumer hire only.
The fact that a sum is termed a deposit, does not necessarily mean that it is to be forfeited on default. This is a matter of interpretation of the agreement. If on the express or implied term of the agreement, the money is not to be returned on default, the question arises as to whether it is a penalty or liquidated damages.
There have been suggestions that where the payment is expressly framed as a deposit, the buyer in default cannot recover the money at all. However other cases allow a deposit to be potentially invalidated as a penalty.
A contract for the sale of land generally provides for a deposit of 10 percent of the purchase price. A 10 percent deposit may be generally forfeited, irrespective of any loss on the part of the seller. This is generally assumed to be enforceable as a liquidated sum. The standard deposit was formerly 25% in the 1970s
There have been cases where the conventional deposit of 10 percent has been held reasonable, Other cases have held that the older conventional deposit of 25 percent was unreasonable.
Expressing Alternative Performance
Where the defendant has the option of performing the contract in a number of alternative ways, damages are assessed on the assumption that the defendant will perform it in the manner most beneficial to himself, and not that most beneficial to the claimant. It might be interpreted to be the case in some circumstances, that the defendant by refusing to perform in one way exercises the option to perform in the other way.
A contract may provide that a party has alternative obligations, one of which is a payment of money and the other performance. The other party may have an option to take performance or payment. A true alternative contract is where the performing party may give performance either as payment of money or performance, at his choice.
The question of a penalty may arise in the context of interest. Certain provisions for additional interest in the event of breach or non-payment, may either be reasonable or be a penalty. The Consumer Credit Act has limited the extent to which “penalty” interest may be applied.
Lenders may require a lump sum payment in the event that a fixed interest contract is broken. The general principles apply. The break will often cause a funding cost or loss of profit to the lender and a lump sum compensation may be legitimate, provided that it is not excessive.
The Consumer Credit Act applies a special rule to consumer credit cases.
In some cases, the stronger party to a contract may impose a very small liquidated sum as the measure of the consumer’s loss. The courts do not generally approach these cases with reference to the principles of liquidated damages. The clauses are usually dealt with as a limitation of liability or exemption clause.
In a business to business contract, the Sale of Goods Act, such clauses in a goods or services contract is valid only if they pass a “fair and reasonable” test where they relate to the core obligations in relation to title, description, fitness and merchantability.
In a business to consumer contract, this is likely to be deemed an unfair term and thereby rendered void. Under the Sale of Goods Act, such clauses are void in a consumer purchase contract for goods and services where they relate to the core obligations in relation to title, description, fitness and merchantability.
References and Sources
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Clark, R. Contract Law in Ireland 8th Ed. (2016) Ch 19
Friel, R. The Law of Contract 2nd Ed, (2000)
McDermott, P. Contract Law (2001) 2nd Ed (2017) Ch 22
Enright, M. Principles of Irish Contract Law (2007)
Clark and Clarke Contract Cases and Materials 4th Ed (2008)
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Poole, J. Casebook on contract law. (2014) 12th edition
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Cheshire, Fifoot and Furmstons, Furmstons and Fifoot Cheshire, Fifoot and Furmston’s law of contract. OUP.
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UK Practitioners Texts
Chitty on Contracts 32nd Edition, 2 Volumes & Supplement (2016)