Liquidated damages clauses (LDs) are used to protect an innocent party's position by quantifying damages payable for a specified breach of a contract. They are routinely used by businesses to protect their position in the event of a breach.
Although a useful tool, parties run the risk that their clause will be construed as a penalty clause and deemed invalid. The law on penalties has evolved over the past 18 months and there now appears to be some certainty, indicating that the bite of penalty clauses may be on the decline.
LD or Penalty?
In 2015 the Supreme Court considered the validity of penalty clauses in the joined cases of Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis  UKSC. A two-fold test was established:
- The first task is to consider whether the obligation is primary or secondary? The penalty rule will only bite if the provision is a primary obligation;
- The next is to determine both the nature of the provision ie - if its intention is to protect the innocent party's legitimate interest, and whether the consequence of a breach would be out of all proportion.
Refreshingly, the two-fold test allows for a wider consideration of the unique interests of the innocent party, meaning each clause will be considered in the backdrop of each party's competing commercial interests and aims.
In Vivienne Westwood v Conduit Street Development Ltd  EWHC 350 (Ch), fashion retailer Vivienne Westwood entered into a lease of retail premises. A side letter was subsequently entered into, which provided for the landlord to accept a reduced rent, on the condition that a list of specified requirements were satisfied. The landlord later contended Vivienne Westwood had breached the lease and therefore pursued his right to terminate the side letter, demanding payment of the higher rent.
The Court determined that the payment of the higher rent, pursuant to the side letter, was a secondary obligation, only enforceable upon breach. The first hurdle of Madkessi was therefore not met. The Court considered the obligation upon Vivienne Westwood to pay the higher rent, with retrospective effect, was wholly disproportionate to any likely losses sustained by the landlord resulting from the breach. The Court confirmed this was to be the case, irrespective of either the actual consequences arising from the breach or the nature of the breach.
Vivienne Westwood v Conduit highlights the current trend that the Court are often unwilling to enforce significant termination payments, regardless of the gravity of the breach. The decision also underpins the importance of first determining whether the provision fashions a primary or secondary obligation. At first glance this is not always clear, but it is vital to consider as only primary obligations will fall within the scope of the penalty rule.
Practical tips to make your LD enforceable and back in fashion
Each case is determined on its individual facts but there are a number of guidelines to follow when drafting an LD clause:
- Ensure the clause bites upon breach of a primary obligation, not merely secondary
- Where possible seek to develop a scale of different sums payable, in line with the corresponding nature of the breach
- Liaise with the other party pre-contract, in particular the justification for the cause and nature of the business interest being protected
- Retain calculations to demonstrate the LD aligns with the likely damages