Friday, January 28, 2011

Penalties versus Liquidated Damages

Penalty clauses are terms of contracts that seek to impose an obligation to pay a sum of money in the event that the contract has been breached. A traditional penalty clause amount would include an amount the far exceeds the amount of damages that would be sustained. In many jurisdictions penalty clauses are not enforceable as a matter of public policy. The rationale is that contract terms should not be used for party to profit from the breach of a contract by the other party. 

Penalty clauses are different than clauses for liquidated damages. Liquidated damages clauses also imposes an obligation to pay a sum in the event of a Breach, however with liquidated damages the intent is to only recover the amount of the damages you sustain. So the real difference between the two is whether you are trying to profit from the breach.

Calling a clause “liquidated damages” does not make it a true liquidated damages provision. In interpreting it a court would apply several tests to determine whether it is a penalty or a liquidated damage. It would be considered a penalty if:
1. The amount payable is excessive when compared to loss*.
2. The amount payable is greater than what should have been paid
3. The amount payable would apply to minor versus major breaches.

*Liquidated damages clauses must be a genuine estimate of the loss to be suffered by the party in the event of a breach. Whether the term is a penalty clause or not is determined as of the time the contract was formed. The amount only needs to be a genuine estimate of the loss at that time.  This means that irrespective of whether the loss would have been greater or smaller at the time of the actual breach does not apply as the parties agreed to establish that as the amount. Where a non-breaching party made a genuine effort to determine their loss and has acted in good faith, the clause will not be classified as a penalty.

To avoid having a liquidated damages term from being considered a penalty the amount needs to be a reasonable reflection of the non-breaching party’s expected loss for the breach. That means that a single liquidated damages amount should not be applied to all breaches. If the intent is to apply liquidated damages to multiple different types of breaches, you should tailor the amount of the liquidated damages for each different breach so each represents a reasonable reflection of the loss for that breach. Most of the time liquidated damages is applied only to the failure to deliver on time.
Amounts payable for performance are not penalty clauses if the performance is not met. For example if you included a bonus for early completion of work and the Supplier failed to complete the work early, the failure to pay the bonus would not be a penalty or liquidated damage as they are not connected with a breach.

The value of liquidated damages provisions is the parties agree on the amount in advance and it relieves the non-breaching party from having to prove their damage in court. The only thing that the breaching party can challenge is whether there was a breach. They could challenge that amount as representing a penalty, but if the amount was properly established as a reasonable reflection of the damage and was agreed by the parties, courts would most likely will not view it as a penalty.


  1. Thank you very much. Very clearly explained. Very judicious to make the difference between these two notions.

  2. Yes, great explanation! Greetings from Denmark