Penalty

A recent case looks at a "liquidated damages" clause and when this type of clause is enforceable.

A recent case looks at a "liquidated damages" clause and when this type of clause is enforceable.

It is not uncommon, particularly in a services contract, for a contract to provide that in the event of a delay or problem with the service caused by one party, that party has to pay the other a pre-defined sum of money to compensate it for the delay.  This is sometimes expressed as a sum of money payable per day that the delay lasts, for example.

The recent case of McAlpine v Tilebox [2005] EWHC looked at just such a clause and whether or not it was enforceable.  The case concerned a clause providing for payment at a defined rate per day of delay. 

The potential problem with this type of contractual provision is that, in order to be enforceable, the amount payable must be a reasonable pre-estimate (as at the date of entering the contract) of the loss likely to be suffered by the person who gets the payment as a result of whatever event triggers it.  If the amount payable exceeds what could be regarded as a reasonable pre-estimate, then it is what is called a "penalty" and it will not be enforceable.

In this case, the Court decided that the clause was enforceable.  In doing so, it pointed out that in order to decide whether or not a provision is a reasonable pre-estimate, you should bear in mind the following:

- Whether or not a provision for payment was a reasonable pre-estimate had to be assessed objectively - that is, would a "reasonable man" looking at it at the time the contract was entered into have thought that the amount payable was a reasonable pre-estimate of the loss likely to be suffered.

- Generally speaking, there had to be an unreasonable difference between the pre-estimated damages and the damages that were (objectively speaking) likely to be suffered before a clause would be held to be unreasonable and unenforceable.

- The honesty (or otherwise) of the person who actually makes the estimate is not relevant.  So, if someone honestly but mistakenly radically overestimates the loss likely to be suffered, the clause may still be unenforceable as a penalty even though the estimate was honest.

- Provided that, objectively speaking, the amount payable was a reasonable pre-estimate of the likely loss at the time the contract was entered into, it does not then matter if, when it actually comes to invoke the clause, it turns out that the loss suffered is not, in fact, exactly the same as the estimate.  In other words, estimation in these circumstances is an inexact science and, provided your estimate was objectively reasonable, you do not have to be exactly right.