Many businesses will be familiar with the concept of the liquidated damages clause; an agreement between parties that a specified sum shall be payable upon a breach of contract. The purpose of a liquidated damages clause is to fix the sum which is to be paid on breach.
The general rule is that a liquidated damages clause is enforceable and the sum specified in such clause recoverable provided that the clause does not constitute a penalty. In the event that the clause does constitute a penalty, it will only be enforceable to the extent of the actual loss suffered.
The traditional definition of a penalty is found in the decision in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79; “The essence of a penalty is a payment of money stipulated as in terrorem (in fear) of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage.” The decision sets out four tests to determine if a contractual provision constitutes a penalty:
1. if the sum stipulated is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach then the provision will be penal;
2. if the breach consists only of the non-payment of money and the provision provides for the payment of a larger sum then the provision will be penal;
3. a presumption that the provision is penal if the same sum is payable in various events of differing gravity; and
4. the impossibility of precisely pre-estimating the true loss would not in itself render a provision penal.
The recent case of ParkingEye Ltd v Beavis  UKSC 67 has updated the rule on penalty clauses to allow for consideration of the “legitimate interest” of the claimant in enforcing the clause.
It was argued that an £85 parking charge levied on Mr. Beavis by ParkingEye for overstaying in a car park was a penalty as it was argued that it far too high to be a genuine pre-estimate of the loss that ParkingEye suffered as a result of Mr. Beavis’ breach of contract. The Court found that the test for whether a provision constituted a penalty was whether; “the impugned provision is a secondary obligation which imposes a detriment on the contract breaker out of all proportion to any legitimate interests of the innocent party in the enforcement of the primary obligation”.
Whilst a charge of £85 may not constitute a genuine pre-estimate of the losses suffered by ParkingEye, the charge was not a penalty as ParkingEye had a legitimate interest in charging overstaying motorists extending beyond the recovery of loss. ParkingEye would not have been able to charge a sum out of all proportion to its legitimate interests but in the court’s view £85 was not out of all proportion.
The test as to whether a liquidated damages clause is enforceable can therefore now be stated as:
1. is the clause a secondary obligation (i.e. an obligation arising only if a corresponding primary obligation is not or cannot be fulfilled)?
2. is the clause in question a genuine pre-estimate of the innocent party’s loss? If not, then;
3. does the innocent party have a legitimate interest in requiring the defaulting party to pay a sum in excess of the loss the innocent party has actually suffered? (for example ParkingEye’s legitimate interest was in imposing the charge to manage the efficient use of the car park, by deterring motorists occupying spaces for long periods, and providing an income stream to enable ParkingEye to meet its costs of the scheme and make a profit from its services) If yes, and …
4. The charge is not out of all proportion to the legitimate interest,
then it should not contravene the penalty rule.
If you’re considering incorporating a liquidated damages provision into any contractual relationship it’s important to bear in mind the following key points:
• Ensure that you have undertaken an adequate process to determine a pre-estimate of the loss likely to be incurred;
• As far as possible keep a record of how the levels of liquidated damages are to be quantified;
• If the charge is likely to be in excess of the losses suffered give consideration to what is a “legitimate interest” (and what is out of all proportion to that legitimate interest).