You may have agreed a sum for breach of contract, but there’s an old common-law doctrine that could see it struck down as a penalty. Fortunately this does not happen often, says Tim Elliott

The law on liquidated damages is odd. English courts are well known for holding that contracts should be upheld - pacta sunt servanda, to use the Latin tag. However, where the parties have agreed for a specified sum or sums to be paid in the event of a breach of contract, it is possible for that provision to be struck down as a penalty.

The benefit of parties agreeing what damages should be paid in the event of breach has long been accepted. Nevertheless the unique remedy of such a clause being held invalid remains. Judges have given up trying to explain why this old common-law doctrine exists.

Lord Diplock in Robophone vs Blank (1966) said that he would make no attempt where so many others had failed to rationalise the rule. Lord Justice Jackson in Alfred McAlpine vs Tilebox (2005) pointed out that it was an anomalous feature of the law of contract, which was not part of any wider doctrine that required the court to rewrite contracts. During the 19th century the courts moved away from the notion that they would mend unfair bargains on an equitable basis. Nevertheless, the rule about penalty clauses survived from an earlier age.

The House of Lords case of Dunlop Pneumatic Tyre vs New Garage and Motor Company (1915) contains a well known passage that is often quoted as setting out guidelines to the doctrine. The language used sounds legalistic and odd to modern ears - for example: “The essence of a penalty is a payment of money stipulated as in terrorem of the offending party”, and, “it will be held to be a penalty if the sum stipulated for is extravagant and unconscionable”.

During the 19th century the courts moved away from the notion that they would mend unfair bargains on an equitable basis. Nevertheless, the rule about penalty clauses survived from an earlier age

Fortunately in recent years the courts have moved away from such antiquated language and addressed the topic in more modern terms. They have also emphasised how a liquidated damages clause being struck down as a penalty is the exception rather than the rule. Three cases in particular stand out.

In Lordsvale Finance vs Bank of Zambia (1996) Mr Justice Coleman expressed the essential test as follows: “Whether a provision is to be treated as a penalty is a matter of construction to be resolved by asking whether at the time the contract was entered into, the predominant contractual function was to deter a party from breaking the contract or to compensate the innocent party for breach.”
He added that that question could be answered by comparing the amount that had been agreed be payable on breach with the loss that might actually be sustained if the breach occurred.

In the second case, Murray vs Leisureplay (2005), all three judges in the Court of Appeal quoted Mr Justice Colman’s test of “predominant function to deter” with apparent approval. However they differed to some extent in relation to the second limb of his approach.
Lady Justice Arden placed some emphasis on the comparison between the sum agreed in the contract to be paid on breach and the amount that would actually be suffered and recoverable as damages for breach of contract at common law. Lord Justices Clarke and Buxton played down the importance of this comparison. Lord Justice Clarke said that he did not read Mr Justice Coleman
as saying that if the comparison disclosed a discrepancy, it followed that the clause was a penalty. The comparison was relevant but no more than a guide.

Lord Justice Buxton said that reliance on the comparison introduced a rigid and inflexible approach into what should be a broad and general question. It was also inconsistent with warnings by past eminent judges that great caution should be used before striking down a clause as penal. As Lord Woolf said in AG Hong Kong vs Phillips, it is normally not enough simply to show that the agreed damages provision could result in the innocent party receiving more than its actual loss.

The third case is Alfred McAlpine (see above). This concerned a construction contract. It contains a useful analysis of the authorities and points out how unusual it is for liquidated damages provisions to be struck down. The rule may have been established in an earlier age but it is often an uphill task today to employ it successfully.

Tim Elliott is a barrister at Keating Chambers