Liquidated damages - effective and enforceable?

Liquidated damages are pre-determined sums that contracting parties agree will be payable upon specific breaches of contract. A well thought out liquidated damages clause should be a genuine pre-estimate of the loss that would likely be suffered by the innocent party, calculated at the time of contract formation.

The purpose of including a liquidated damages clause does include focusing the parties minds on the consequences of breach and therefore increases the chance of adherence to the contract. Sometimes, parties get tempted to include a very high and disproportionate number for liquidated damages into a contract as a way to scare the other party against breach. This sometimes happens with confidentiality agreements. This type of approach is risky and may well not be enforceable.

Enforceability Under UK Law

Liquidated damages clauses, even where contractually agreed, are only potentially enforceable under UK law, but with important limitations. Currently, a liquidated damages clause will be enforceable unless:

• It imposes a detriment on the contract-breaker that is "out of all proportion" to the innocent party's legitimate interest in enforcing the primary obligation

• The clause is deemed to be extravagant, exorbitant, or unconscionable

This means a liquidated damages clause doesn't necessarily need to be a perfect calculation of anticipated loss to be enforceable, as long as it protects a legitimate business interest and is not grossly disproportionate.

Contracts which often include liquidated damages clauses

• Construction Contracts -  damages typically calculated as a daily or weekly rate for delays in completion

• Software Implementation Agreements - often include liquidated damages for delays in system delivery or failures to meet performance metrics

• Commercial Leases - may include liquidated damages for late vacation of premises or early termination

• Service Level Agreements - often incorporate liquidated damages in the form of service credits for performance failures

• Supply Contracts - may include liquidated damages for late or incomplete deliveries

• Distribution Agreements - can include liquidated damages for failures to meet minimum purchase requirements

• Outsourcing Contracts- typically include complex liquidated damages regimes for service failures

• Share Purchase Agreements - for breaches of warranties or covenants

Risks

1. Enforceability Risk - if poorly drafted, the clause may be deemed a penalty and rendered unenforceable, leaving the innocent party to prove actual damages

2. Limitation Risk - a liquidated damages clause may act as a cap on recoverable damages, potentially limiting recovery if actual damages exceed the pre-agreed sum

3. Under-compensation Risk - if the pre-estimated damages are lower than actual damages, the innocent party cannot claim the difference

4. Over-specification Risk: If the clause is too narrowly drafted, it may not cover all types of breaches or may be inapplicable in certain circumstances

5. Amendment Risk - failure to review and update liquidated damages provisions when contract values change can render them unenforceable

6. Uncertainty Risk  - ambiguous drafting can create uncertainty about when and how the clause applies, potentially leading to disputes

How We Can Help

• Our commercial contracts team have has extensive experience drafting and reviewing liquidated damages provisions across various industry sectors.  We provide strategic advice on negotiation positions and fallback options.

• Our dispute resolution and enforcement solicitors can assist with advising on the enforceability of liquidated damages provisions and calculating and proving damages when liquidated damages clauses are or may be unenforceable.