Author: Narmin Huseynzada, LLB, Baku State University, 2016-2020
Editor: Bader Kabbani, LLM International Commercial and Economic Law, SOAS, University of London, 2020-2021
Liquidated damages (LD) clauses are designed to protect the innocent party from the breach of contractual obligations. They facilitate the demand of damages as a creditor with no obligation to prove its loss suffered from breach. However, it is not enough to insert an LD clause into the contract since they should satisfy several criteria for being enforceable. In practice, there are some differences in interpreting LD clauses. This article aims to show these differences and how common and civil law countries approach LD clauses.
Definition and purpose.
LD clause is one of the remedies aimed at protecting the innocent party in case of a breach by the other party. The main purpose of the LD clause is to define a certain specified sum and thus to make clear to the parties at the time of contracting the consequences of breach. LD clause is a helpful tool for the innocent party as it prevents the time-consuming and sometimes difficult procedure of proving the damage and saves additional costs that might exceed the actual loss. Additionally, this clause plays a shielding role for possible breaches and incentivizes parties to fulfil the contract without delay or other infringements.
Liquidated damages are more than the actual loss.
Despite advantages, LD clauses have several shortcomings. Parties often underestimate or overestimate the amount of LD at the time of the conclusion of the contract. In practice, there is a difference in the treatment of excessive LD. In common law countries, a sum that is much higher than the actual loss is considered void. Because the courts accept those clauses as a penalty. The main logic is that the aggrieved party is entitled to compensate for his loss and no more. However, penalty clauses serve as if the innocent party punishes the debtor for his breach. The UK Supreme Court explains in Cavendish Square Holding BV v. Talal El Makdessi case that: “The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or some appropriate alternative to performance” [1]. Therefore, courts while evaluating the enforceability of LD clauses take into consideration whether 1) the LD clause seeks to protect a legitimate interest of an innocent party; 2) the remedy is proportionate to that legitimate interest.
It should be noted that the penalty rule is only applicable if the debtor breached a conditional primary obligation. The Supreme Court continues in its reasoning that: “where a contract contains an obligation on one party to perform an act and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty” [2].
In civil law countries, if the amount of LD exceeds the actual loss, then the LD clause is still enforceable. The main idea here is that parties are rational, if they mean to penalize the defaulted party, then it is efficient for them. Otherwise, the agreement would not be reached [3]. However, in France and Azerbaijan, for example, a court has the power to reduce the amount of LD which is excessively high than the actual loss.
If the court finds the LD clause unenforceable, then the innocent party cannot refer to general damages as an alternative in common-law countries. In contrast, in most civil law countries, if for any reason the LD clause becomes unenforceable, then the aggrieved party can still claim general damages. For example, as to the Civil Code of Azerbaijan, the party can choose either LD or general damages, or claim LD and at the same time as part of the general damages that are not covered by the LD clause.
Liquidated damages are less than the actual loss.
What if the sum of LD is less than the actual loss? The general view in common law countries is that the innocent party cannot claim actual loss even if the LD is less than the specified amount. In IPN Medical Centres Pty Ltd v. Van Houten, the Supreme Court of Queensland stated that the LD clause acts as a liability cap, therefore the party could not ignore agreed damages and demand larger general damages to compensate for its loss [4]. In most jurisdictions, courts are keen to accept the LD clause as an exhaustive remedy. But it is not the uniform approach in all common law countries. In the Ravenstar case, damages provisions provided that if a purchaser defaulted, the other party had the option to retain deposits as LD or demand actual damages instead. The plaintiffs disputed the enforceability of such a clause. The Colorado Supreme Court in its judgment concluded that the contract giving a party the option between LD and actual damages is enforceable as to the principle of freedom of the contract [5]. However, there is one condition that the Supreme Court and other civil law countries agreed on that the party cannot claim LD and actual damages at the same time.
Conclusion.
The analysis in the article shows that there is no universal approach regarding the LD clauses and parties should carefully choose the governing law as in case of dispute the application of the LD clause can be different as to jurisdictions. Whether the LD clause is interpreted as to the rules of common law or civil law countries, the main purpose of such clauses should be to fairly compensate the innocent party and force the debtor to perform its obligations. But it does not mean the LD clause should serve only on behalf of the innocent party. The debtor should not be interested in paying LD as its less costly than the performance of the obligation itself. On the other hand, parties should refrain from excess compensation as it might make the defaulted party economically beneficial to demand that specified sum instead of performance.
References.
- Cavendish Square Holding BV v. Talal El Makdessi, UKSC 2013/0280, para 32, 04 Nov 2015
- See supra note 3, para 14.
- G. De Geest. Penalty clauses and liquidated damages // Encyclopedia of Law and Economics, Volume III. The Regulation of Contracts, Cheltenham, Edward Elgar, 2000, p. 147
- IPN Medical Centres Pty Ltd v Van Houten QSC 204, 23 July 2015
- Ravenstar, LLC v. One Ski Hill Place, LLC, 401 P.3d 552, 11 Sep 2017
Bibliography.
- Cavendish Square Holding BV v. Talal El Makdessi, UKSC 2013/0280, para 32, 04 Nov 2015
- See supra note 3, para 14.
- G. De Geest. Penalty clauses and liquidated damages // Encyclopedia of Law and Economics, Volume III. The Regulation of Contracts, Cheltenham, Edward Elgar, 2000, p. 147
- IPN Medical Centres Pty Ltd v Van Houten QSC 204, 23 July 2015
- Ravenstar, LLC v. One Ski Hill Place, LLC, 401 P.3d 552, 11 Sep 2017
- Brian Eggleston, Liquidated Damages and Extensions of Time: In Construction Contracts, Third Edition, 2009
- Roger Halson, Liquidated Damages and Penalty Clauses, Oxford University Press, First Edition, 2018.
This article is written within the Academic Essay Project (AEP) organised by LAWELS. AEP aims to increase the number of quality academic writings on legal topics, encourage young lawyers to participate in academic writing, and lay the foundation of an online database on legal science. The team of legal editors and legal writers share their knowledge through high-end essays that we are publishing on our website and social media accounts for the world to read and learn from.
The articles on the LAWELS platform are not, nor are they intended to be legal advice. You should consult a lawyer for individual advice or assessment regarding your own situation. The article only reflects the views of the author.