Setting the amount

Following the decision in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67, the amount set for liquidated damages should equate to the legitimate interest of the innocent party in having the contract performed according to its terms.

In most cases this interest will be satisfied by the innocent party receiving compensation for the breach, on the normal basis that this should return the party to the position it would have been in had the breach not occurred.  The amount of liquidated damages should therefore be a reasonable estimate of the potential loss that would be suffered by the innocent party in the event of a breach. 

In practice, this means that the principle that liquidated damages should be a 'genuine pre-estimate' of the damage that would be suffered by the innocent party in the event of a breach remains in force: a liquidated damages provision which was valid under Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79 will be valid under the new tests.

However, the Supreme Court has gone further and has expanded the category of valid liquidated damages clauses. The court accepted that 'there may be interests beyond the compensatory which justify the imposition on a party of an additional financial burden'. The example was given of the maintenance of a system of trade, which will only continue to function if all parties involved subscribe to it. Each case will depend on its particular facts, but it will always be necessary to consider whether there is a legitimate business interest to be protected and, if so, the 'additional financial burden' that may be imposed on the contract breaker, beyond the right to be compensated, must not be 'extravagant, exorbitant or unconscionable'.

In this case, the Supreme Court found that excess parking charge of £85, which applied once a period of free parking was exceeded, did protect a legitimate commercial interest, and was not 'extravagant, exorbitant or unconscionable'. The car park owner, operator and users all had a legitimate interest in maintaining a system which allowed for several hours of free parking, with an excess parking charge if the time limit was exceeded.  The Supreme Court was heavily influenced by the fact that this charge was similar in level to that applied by a number of local authorities and car park operators: it was not 'exorbitant' by reference to the commercial norm of general industry practice.

Estimating the damage that would be caused by a breach of contract - let alone the 'additional financial burden' that may be applied in respect of the further legitimate business interest to be protected - can be a complex exercise and many employers will look for assistance from their professional advisers.

If the amount of liquidated damages is an arbitrary or inflated figure, which does not satisfy the tests set out in the Supreme Court's judgment, it is likely that the contractor will be able to successfully challenge the liquidated damages clause on the basis that it is a penalty. In short, if the liquidated damages rate is not reasonable, there is a risk that the court will not enforce it.

Although the liquidated damages rate must not be a penalty and the compensatory element must be assessed as accurately as possible, the court will not find that the amount of liquidated damages is a penalty simply because it exceeds the actual loss incurred.

In Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] BLR 271 (TCC), it was held that there must be a 'substantial discrepancy' between the level of liquidated damages in the contract and the level of damages which is likely to be suffered before the agreed pre-estimate is treated as a penalty.

This approach was confirmed in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67: to be treated as a penalty, the level of liquidated damages must be "exorbitant" in comparison to the actual damages.

It is also clear that the courts will be reluctant to interfere with a rate of liquidated damages that has been negotiated between properly advised parties of equal bargaining power. This was re-iterated in the Cavendish Square case.

Once the potential loss that would be caused by a breach and the additional financial burden required to protect any other legitimate business interests has been identified and calculated, the liquidated damages rate can be agreed on. This is frequently the subject of intense negotiation, the contractor may be unwilling or unable to bear the full cost and a reduced figure will be agreed. In this case the rate of liquidated damages will effectively act as a limit on the contractors liability, as the level of liquidated damages will be less than the amount of common law damages.

Once agreed and stated in an executed contract, the liquidated damages figure cannot be changed, even if it emerges that the level of liquidated damages is likely to be significantly different to the actual loss. This may mean that an employer recovers liquidated damages when there is little or no actual loss or, conversely, fails to recover anything close to the actual loss it has incurred.

This risk of unfairness to one of the parties is offset by the benefit of certainty as to the level of the damages that would be charged in the event of breach.