Contract interpretation—distinguishing between liquidated damages and penalty clauses
Contract interpretation—distinguishing between liquidated damages and penalty clauses

The following Dispute Resolution guidance note provides comprehensive and up to date legal information covering:

  • Contract interpretation—distinguishing between liquidated damages and penalty clauses
  • Liquidated damages v penalties—when does the issue arise?
  • Liquidated damages clauses—what are they?
  • Penalty clauses—what and why are they unenforceable?
  • When is a liquidated damages clause a penalty clause?
  • Dunlop Pneumatic on penalties and liquidated damages—Lord Dunedin's four propositions
  • Makdessi—developing the propositions as to penalties and liquidated damages clauses
  • Commercial justification—a new approach to whether a clause is a penalty or liquidated damages
  • Social justification for penalty clauses (ParkingEye)?
  • 'True test' for penalties—Supreme Court decisions in ParkingEye and Makdessi
  • more

Liquidated damages v penalties—when does the issue arise?

Parties will sometimes seek to agree in their contract what sums should be payable upon breach of a particular term or several terms. Where they do so, whether or not such a clause will be enforceable will depend on whether the courts construe it as:

  1. a liquidated damages clause (enforceable), or

  2. a penalty (unenforceable)

Understanding how these clauses work and the factors the court will take into account in interpreting them is, therefore, key. Much will turn on the specific circumstances of each case.

Lord Neuberger and Lord Sumption in the 2015 Supreme Court decision in ParkingEye v Beavis and Cavendish v Makdessi stated that the existing rule against penalties is:

‘An ancient, haphazardly constructed edifice which has not weathered well, and which, in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended.’

This Practice Note considers what liquidated damages clauses are and the court's approach when determining whether a purported liquidated damages clause is, in fact, a penalty; tracing the authorities through to how the question should now be approached in light of the ParkingEye decision.

It is clear from the Supreme Court's decision (had it not already been the case) that there is a fundamental difference between a jurisdiction to review the fairness of