A trap that contract drafters often fall into is writing a clause that instead of being liquidated damages, crosses the line into a penalty.
In summary the difference is:
- Liquidated damages: If the amount fixed by the parties is a ‘genuine estimate (or pre-estimate as is commonly written) of the loss by a future breach of the contract, it is liquidated damages.
- Penalty: On the other hand if the amount fixed by the parties is unreasonable then it is probably a penalty.
A clause for liquidated damages will require one party to pay the other party compensation for a breach of the contract. The term “liquidated” means the amount of compensation is either designated or can be accurately calculated.
The amount of compensation that a party should be required to pay, should be a genuine pre-estimate of the loss that would result from a breach of the contract in question.
As opposed to being a genuine pre-estimate, a penalty punishes the party by requiring them to pay a sum that is unconscionable or non-proportional to the loss that would have been suffered.
Some key things to assist in the identification of penalties include:
- the actual effect of the clause rather than the wording of the clause in question;
- whether the clause is a bona fide pre-estimate of (potential) damages;
- the construction of the clause in relation to the context of the contract as a whole; and
- if the payment is of a single amount, whether the amount is proportionate to the breach.
As always expert advice should be sought if you are signing a contract with liquidated damages, or if you are drafting one.
