Discharge of contract and remedies - Liquidated sums and pen...

Learning Outcomes

This article outlines the rules on agreed damages clauses and related remedies in contract law, including:

• Primary obligations and secondary obligations, with emphasis on identifying when a clause is triggered by breach and therefore falls within the scope of the common law penalty rule.
• The traditional Dunlop guidelines and the modern Cavendish/ParkingEye legitimate interest and proportionality test, and how to deploy both frameworks in structured SQE1 problem and multiple‑choice questions.
• Distinctions between valid liquidated damages and unenforceable penalties in commercial and consumer contracts, including deposits, early termination and cancellation fees, interest on late payment, and price‑adjustment mechanisms.
• The legal consequences of a clause being characterised as a penalty, including unenforceability of the stipulated sum, the continued availability of general damages, and the circumstances in which severance and the “blue pencil” test may preserve part of a clause.
• The interaction between the common law penalty doctrine and statutory controls, particularly the Consumer Rights Act 2015 fairness test and the more limited relevance of the Unfair Contract Terms Act 1977 to agreed damages provisions.
• Related concepts that may arise alongside penalties in exam scenarios, such as actions for an agreed sum (debt), forfeiture of deposits, and equitable relief against forfeiture, and how these remedies fit within the overall structure of contractual responses to breach.
• A clear analytical approach for evaluating whether a clause is penal or compensatory, enabling confident, time‑efficient application of the tests to unfamiliar SQE1 fact patterns.

SQE1 Syllabus

For SQE1, you are required to understand how contracts can provide for specific sums payable upon breach, and the legal framework governing these provisions. It is likely you will need to apply the rules distinguishing enforceable liquidated damages clauses from unenforceable penalty clauses to practical scenarios, with a focus on the following syllabus points:

• The definition and purpose of liquidated damages clauses.
• The definition and purpose of penalty clauses.
• The legal tests used to differentiate between liquidated damages and penalty clauses, including the concepts of 'genuine pre-estimate of loss' and the modern 'legitimate interest' test.
• The consequences of a clause being classified as a penalty.
• Key case law such as Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd and Cavendish Square Holding BV v Makdessi.
• The scope of the penalty rule (secondary obligations only), and how deposits, forfeiture, and price-adjustment mechanisms are treated.
• Consumer controls on disproportionate charges under the Consumer Rights Act 2015, including the example of ParkingEye Ltd v Beavis.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary difference between a liquidated damages clause and a penalty clause?
2. True or false? A clause requiring a payment vastly in excess of any possible loss caused by a breach is likely to be enforceable as liquidated damages.
3. Which landmark case introduced the modern test focusing on 'legitimate interest' and proportionality for assessing penalty clauses?
4. If a court determines a clause is a penalty, what remedy is typically available to the innocent party?

Introduction

Parties negotiating a contract often wish to achieve certainty regarding the consequences of a potential breach. One way to do this is to include a clause specifying a fixed sum of money payable by the contract-breaker upon a particular breach occurring. Such clauses aim to pre-determine the damages payable, avoiding the need for the innocent party to prove their actual loss and the potential complexities and costs associated with quantifying damages at common law.

However, the courts exercise control over these clauses. English law distinguishes between liquidated damages clauses, which are generally enforceable, and penalty clauses, which are generally unenforceable. Understanding this distinction and the tests applied by the courts is essential for advising clients on the validity of such terms.

It is also essential to identify the nature of the obligation. The common law penalty rule applies only to secondary obligations—those which impose a detriment triggered by breach of a primary obligation. If a payment term is part of the primary bargain (for example, a price-adjustment mechanism, or a non-breach contingent payment), the penalty rule does not apply. This threshold question—primary or secondary obligation—frames the analysis before applying the modern legitimate interest and proportionality test.

Key Term: Liquidated Damages Clause
A term in a contract that stipulates a specific sum of money to be paid by the party in breach to the innocent party upon a particular breach occurring, representing a genuine pre-estimate of the likely loss.

The purpose of a liquidated damages clause is compensatory, not punitive. It aims to provide a reasonable assessment, made at the time of contracting, of the loss likely to flow from the specified breach. If a clause is deemed to be a valid liquidated damages clause, the stipulated sum is payable upon the breach occurring, regardless of the actual loss suffered by the innocent party. The innocent party cannot claim more than the specified sum, even if their actual loss is greater, nor can the party in breach argue that less should be paid because the actual loss was smaller.

Key Term: Penalty Clause
A term in a contract that stipulates a sum payable upon breach which is extravagant and unconscionable in comparison to the greatest loss that could conceivably follow from the breach, designed to deter breach rather than compensate for loss.

Unlike liquidated damages, a penalty clause is designed to punish the breaching party or act as a deterrent in terrorem (as a threat) against breaching the contract. English courts will not enforce penalty clauses. If a clause is held to be a penalty, it is disregarded, and the innocent party must prove their actual losses and recover damages assessed in the normal way (subject to the rules of causation, remoteness, and mitigation).

Key Term: Primary Obligation
A core contractual promise or price term that defines the parties’ substantive rights and obligations and is not triggered by breach.

Key Term: Secondary Obligation
An obligation that only arises upon breach of a primary obligation (for example, to pay a stipulated sum for delay), and to which the common law penalty rule applies.

Distinguishing Between the Clauses: The Legal Tests

The courts have developed tests to determine whether a clause is a liquidated damages clause or an unenforceable penalty. The label used by the parties (e.g., calling it 'liquidated damages') is not conclusive.

The Traditional Test: Genuine Pre-Estimate of Loss

Historically, the key test was whether the stipulated sum was a 'genuine pre-estimate of loss' likely to be caused by the breach, judged at the time the contract was made. In Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, Lord Dunedin outlined guidelines:

• A sum is likely a penalty if it is 'extravagant and unconscionable' compared to the greatest conceivable loss.
• A sum is likely a penalty if the breach consists only of not paying a sum of money, and the stipulated amount is greater than the sum that ought to have been paid.
• There is a presumption (rebuttable) that it is a penalty if a single lump sum is payable upon the occurrence of one or more events, some serious, some trifling.
• It is no obstacle that precise pre-estimation is difficult; this may be exactly when parties agree a sum.

This traditional approach still helps frame proportionality, particularly in straightforward cases such as late payment or minor delay, but it is no longer the sole test.

The Modern Test: Legitimate Interest and Proportionality

The Supreme Court reformulated the test in Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67. The focus shifted from the 'genuine pre-estimate' concept to whether the clause protects a legitimate interest of the innocent party and whether the detriment imposed on the breaching party is proportionate to that legitimate interest.

Key Term: Legitimate Interest
In the context of penalty clauses, an interest beyond simply compensating for financial loss, which the innocent party is justified in protecting through the clause (e.g., maintaining goodwill, enforcing non-compete covenants, ensuring operational efficiency, or managing scarce resources).

The modern test asks:

1. Is the clause engaged by a breach (i.e., is it a secondary obligation)? If not, the penalty rule does not apply.
2. If yes, does the clause impose a detriment on the contract-breaker that is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation?

If the clause protects a legitimate interest and the detriment is not 'extravagant', 'exorbitant', or 'unconscionable' in comparison to that interest, it is likely enforceable as a liquidated damages clause. If it is out of all proportion, it is likely an unenforceable penalty.

The Supreme Court stressed context. Where sophisticated commercial parties of equal bargaining power agree terms after negotiation, the court is slow to interfere. In consumer settings, the assessment of proportionality is tempered by statutory fairness controls.

Primary vs Secondary Obligations and ‘Disguised’ Penalties

The penalty rule only applies to a secondary obligation triggered by breach. A clause that adjusts price or allocates risk without reference to breach is a primary obligation and not reviewable under the penalty rule. That said, a ‘disguised’ penalty—an obligation drafted as a price term but functioning in substance as a sanction for breach—may still be scrutinised. After Cavendish, however, courts have been reluctant to expand the rule beyond secondary obligations, preferring to address abusive terms in consumer settings through statutory fairness.

Key Term: Action for an Agreed Sum (Debt)
A claim to enforce a primary payment obligation under the contract (e.g., the price), to which the penalty rule does not apply.

Worked Example 1.1

A construction contract provides that the contractor must pay the employer £10,000 for every week of delay beyond the agreed completion date. The project is complex, and accurately predicting the employer's losses due to delay (e.g., loss of rental income, disruption to business) is difficult. Is this clause likely enforceable?

Answer:
This clause is likely enforceable as liquidated damages. £10,000 per week might represent a genuine attempt to pre-estimate the loss caused by delay in a large construction project, where quantifying actual loss would be complex. It protects the employer's legitimate interest in timely completion. Unless the sum is shown to be extravagant or unconscionable compared to the likely losses, it probably satisfies the modern test.

Worked Example 1.2

A software licensing agreement states that if the licensee uses the software on more than the permitted five devices, the licensee must pay a one-off sum of £1,000,000. The licensor's actual loss from such a breach would typically be the cost of additional licences, amounting to perhaps £5,000. Is this clause likely enforceable?

Answer:
This clause is likely an unenforceable penalty. The sum of £1,000,000 appears extravagant and out of all proportion to any legitimate interest the licensor might have in enforcing the five-device limit. The greatest conceivable loss appears significantly lower. It seems designed primarily to deter breach rather than compensate for loss.

Worked Example 1.3

A share sale agreement contains restrictive covenants on the seller. If the seller breaches a non-compete covenant, two terms are engaged: (i) deferred consideration ceases to be payable; and (ii) the buyer may buy back the seller’s remaining shares at a discounted valuation. Are these provisions penal?

Answer:
They are likely enforceable. First, stopping further deferred consideration can be a primary price-adjustment term, not a secondary obligation, so the penalty rule does not apply. Secondly, even where an option to buy at a discount is triggered by breach, it can reflect a legitimate interest in enforcing non-competes and protecting goodwill; if the discount is not out of all proportion to that interest, the term is not a penalty (consistent with Cavendish).

Worked Example 1.4

A buyer pays a 25% deposit on a contract for the sale of land expressed as “non-refundable” if the buyer fails to complete. The buyer defaults. The seller seeks to forfeit the full 25%. Is the forfeiture likely to stand?

Answer:
Not in full. A reasonable deposit is typically around 10% in land transactions; a 25% payment may be treated as excessive and penal in effect. The court can grant relief against forfeiture and require repayment of the excess, allowing the seller to retain only what is reasonable while also awarding damages for actual loss as appropriate.

Worked Example 1.5

A gym’s standard terms provide for an “early termination fee” equal to all remaining monthly fees to the end of the fixed term if the member cancels early for convenience. The member cancels six months into a 12‑month contract. Is the fee enforceable?

Answer:
In a consumer context, the term must be fair under the Consumer Rights Act 2015 and, if triggered by breach, it also engages the penalty rule. An automatic charge for all remaining months, without allowing for saved costs or resale, risks being out of proportion to the trader’s legitimate interest and may be unfair and/or penal. A modest, cost-reflective fee to cover genuine losses could be justified; a blanket recovery of all future fees is vulnerable.

Worked Example 1.6

A supply contract states that if the buyer is late paying any invoice, the seller may charge interest at 12% above base rate per annum on the overdue balance. Is that interest term reviewable as a penalty?

Answer:
Yes, the penalty rule can apply to interest for late payment because it is triggered by breach (non‑payment on time). The clause must be judged against the seller’s legitimate interest (e.g., compensating financing cost, incentivising prompt payment). A commercially standard or moderately elevated rate will likely be proportionate. An exorbitant rate with no justification could be penal; statutory interest remains a useful benchmark where applicable.

Exam Warning

Do not rely solely on the label given to a clause by the parties. A clause labelled 'liquidated damages' can still be a penalty if it fails the legal tests, and vice versa (though less common). Focus on the substance and effect of the clause compared to the legitimate interests and potential losses.

Effect of a Clause Being a Penalty

If a clause is deemed a penalty, it is unenforceable beyond the actual loss suffered. The innocent party is not prevented from claiming damages for the breach, but they must prove their actual loss in the usual way, subject to the rules on causation, remoteness, and mitigation. They cannot recover the penalty sum stipulated in the contract.

The rest of the contract remains in force. Courts will not rewrite the parties’ bargain to substitute a different sum, but where the clause is severable (for example, a composite provision with distinct promises), a valid part may be saved if it can be removed without altering the remaining language (the “blue pencil” test). Severance is not a device to salvage an excessive sum by redrafting; it only applies where the invalid part can be deleted cleanly.

Practical consequences include:

• If a liquidated damages clause is valid, it generally displaces a claim to general damages for the same breach.
• If a clause is penal and unenforceable, the injured party must quantify loss; if no loss is proved, the recovery may be nominal.
• A claim for an agreed sum (debt) enforcing a primary obligation (e.g., the price) is not affected by the penalty rule.

Statutory Controls

While the primary control over penalty clauses comes from common law, statutory provisions, particularly in consumer contracts, may also be relevant.

• Consumer Rights Act 2015: Part 2 of the CRA 2015 subjects terms in consumer contracts to a fairness test. A term requiring a consumer to pay a disproportionately high sum in compensation could be deemed unfair and therefore not binding on the consumer (see Sch 2, Part 1, para 6). Transparency (plain and intelligible language) and prominence matter; unclear default charges are vulnerable. The Supreme Court in ParkingEye v Beavis upheld an £85 parking charge as fair and not penal because it served a legitimate interest (space turnover and funding of operations) and was proportionate in the consumer context.

• UCTA 1977: Although directed primarily at exclusion and limitation clauses in the B2B context, UCTA has limited application to agreed damages clauses. It does not directly regulate liquidated damages/penalty clauses, but other liability-limiting provisions associated with a breach remain subject to reasonableness.

• Other regulatory oversight: Sector-specific regulation (for example, communications or financial services) and regulator guidance can shape the assessment of fairness of default and termination charges in consumer contracts.

Key Term: Deposit
A prepayment intended as security for performance. A reasonable deposit (often 10% on land sales) may be forfeited on default; an excessive ‘deposit’ can be relieved against in equity.

Key Term: Relief Against Forfeiture
An equitable remedy by which the court may relieve against the forfeiture of property or payments where it would be unconscionable to allow forfeiture, commonly applied to excessive deposits or proprietary interests.

Drafting and analysis pointers

• Identify whether the term is triggered by breach (secondary) or is part of the pricing or risk allocation (primary). The penalty rule only applies to the former.
• Ascertain the legitimate interest protected (timely completion, non‑compete enforcement, parking space turnover, brand protection, network efficiency).
• Test proportionality: is the detriment “out of all proportion” to that interest? Consider industry norms, negotiation between sophisticated parties, and the availability of other remedies.
• In consumer contracts, evaluate fairness under the CRA 2015 in parallel with the penalty rule, focusing on transparency and proportionality.
• Where liquidated damages are used, define the trigger precisely, avoid sweeping application to trivial breaches, and consider caps or tiering that reflect gradations of severity.

Revision Tip

Remember that the modern test from Cavendish is broader than the traditional Dunlop test. Consider not just financial loss, but any other legitimate commercial interests the innocent party might be protecting when assessing proportionality.

Key Point Checklist

This article has covered the following key knowledge points:

• Liquidated damages clauses specify a pre-agreed sum payable on breach, representing a genuine pre-estimate of loss or a proportionate protection of a legitimate interest.
• Penalty clauses specify a sum payable on breach that is designed to deter breach and is disproportionate to any legitimate interest or likely loss.
• The penalty rule applies only to secondary obligations triggered by breach; primary obligations (including price-adjustment mechanisms) fall outside it.
• Liquidated damages clauses are generally enforceable; penalty clauses are generally not, with the consequence that only provable loss is recoverable.
• The traditional test focused on whether the sum was a 'genuine pre-estimate of loss' (Dunlop).
• The modern test asks if the detriment imposed by the clause is out of all proportion to any legitimate interest of the innocent party (Cavendish/ParkingEye).
• If a clause is a penalty, the innocent party must prove actual loss to recover damages; courts do not substitute a different sum for the parties.
• Deposits are generally forfeitable only to a reasonable extent; excessive “deposits” can attract relief against forfeiture.
• Statutory controls, particularly the Consumer Rights Act 2015, may also apply—terms requiring disproportionately high compensation can be unfair and non-binding.
• Debt claims for agreed primary sums are not affected by the penalty rule.

Key Terms and Concepts

• Liquidated Damages Clause
• Penalty Clause
• Legitimate Interest
• Primary Obligation
• Secondary Obligation
• Action for an Agreed Sum (Debt)
• Deposit
• Relief Against Forfeiture