A contract may contain a liquidated damages clause, saying that a certain sum of money is payable in the event of breach. The danger, of course, is that this provision will be struck out as an unenforceable ‘penalty’.

The classic test of what amounts to a penalty was laid down in Dunlop [1915], which said it would only be valid if it was a ‘genuine covenanted pre-estimate of damage’. So, if the sum was considered by the parties at the time of entering into the contract to be a genuine pre-estimate of the loss that might be incurred, then it will not be a penalty. Putting it another way, there is a distinction between a fixed payment that is ‘essentially compensatory in nature’ (which will be valid) and one that is there to ‘deter the party in question by breaking the contract by providing for a punitive level of payment’ (which will be invalid).

In practical terms, for an agreed pre-estimate to be found unreasonable ‘there must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages that is likely to be suffered’ (Alfred McAlpine v Tilebox [2005]), and:

‘Because the rule about penalties is an anomaly within the law of contract, the courts have pre-disposed, where possible, to uphold contractual terms which fix the level of damages for breach. This previous position is even stronger in the case of commercial contracts freely entered into between parties of comparable bargaining power.’

If you are drafting a contract that contains a liquidated damages clause, then do try to quantify the loss beforehand. Use a ‘best guess’ procedure and keep a record of the underlying calculations, and logic followed. The more detail you can record about the justification for such a clause, then the more likely it will be upheld. You could even consider setting out the calculation, and providing a worked example, in the contract. Furthermore, when doing your calculations make sure that you do it on a net basis (eg make allowance for any money that will be saved by the non-defaulting party). At the same time, it is best to have a clause confirming that liquidated damages have been agreen in arm’s-length negotiations by both sides, who have been separately advised (with a clause stating that it does represent a genuine and reasonable estimate of damages and loss, and takes into account mitigation of loss). Source: Herbert Smith.