Liquidated damages (“LDs”) clauses are a common contractual feature in high value and/or complex commercial health projects. They are a useful tool for both customers and suppliers. From a customer’s perspective, they incentivise suppliers to perform in accordance with contractual expectations. For suppliers, they can provide commercial comfort that additional costs can be recovered if a customer fails to perform obligations which impact on the supplier’s performance and/or costs.
They are often used as a remedy for critical aspects of project implementation and/or transition periods and including a LDs clause in a contract shines a light on both parties’ obligations, which can be particularly helpful when there are inter-dependent obligations.
Such focus can ensure contractual ambiguities or misunderstandings are addressed from the outset and the contract can be clearly drafted to reflect each party’s obligations. This, in turn, helps to reduce operational risk. It’s important that a LD clause is carefully drafted so as to avoid any risk of a court deeming the clause to be unenforceable.
This alert considers: (1) the advantages of liquidated damages clauses; and (2) key drafting issues to avoid any risk of the provision(s) being deemed to be unenforceable.
Advantages of a liquidated damages clause
Where a party breaches a contract, the general position is that the non-defaulting party will be able to pursue a claim for damages. A breach of contract claim will need to be enforced via the courts which takes time and expense (even if they are settled out of court). However, a LDs clause provides for a pre-agreed sum of money to be payable in the event of a specified breach of contract. This circumvents the need to pursue damages claims via the courts, thus saving time and money.
LDs clauses are often drafted for the benefit of the customer, as it is the customer requiring the performance of services and/or the provision of goods in specified timeframes. However, in complex contracts where, for example, delivery and/or implementation/mobilisation relies heavily on the interfacing of customer and supplier responsibilities, LDs clauses can also be included to protect the supplier.
Advantages of including a LDs clause:
- they provide an incentive for performance, as well as certainty with respect to recoverable losses and quantum;
- the non-breaching party only has to show that the relevant breach has occurred and does not have to wait for any loss to crystallise in order to prove actual loss;
- factors such as causation, remoteness, mitigation, and proof of loss do not affect claims for LDs;
- the amount recoverable is not left for a court to decide; and there is no need to assess damages. This therefore simplifies the procedure for applying for default or summary judgement (where appropriate);
- LDs can be an effective way to resolve breaches in long-term contracts by preserving the on- going commercial relationships. For complex, long term contracts, termination and/or lengthy damages claims are not always viable options when such services are required to support on- going clinical or management functions and cannot be replaced easily or at speed; and
- they provide financial certainty for the party seeking to rely on the LDs clause, as LDs are payable up until the date of termination of the contract (with general damages being recoverable from termination onwards).
It should of course be noted that if a LDs clause is enforceable, the breaching party is liable for the financial remedy that it has agreed to notwithstanding the loss suffered by the non- breaching party - this is why it is so important to ensure that the commercial quantification of loss is very carefully considered. Including in a contract LDs that are either too high or too low can be problematic for both sides, as explored below.
Drafting considerations
Setting the amount of the LDs is a commercial decision. However, the clause also needs legal input to ensure any amounts are based on a realistic assessment of the potential loss that could be suffered, along with the protection of the legitimate interests of the non-breaching party.
It’s important to note:
- if LDs are too high, there is a risk that a court will deem that the provision is unenforceable on the basis that it is a “penalty”. In this scenario, the non-breaching party would have to resort to a claim for general damages (see our comments on this above); and
- if the LDs are set too low, and the non-breaching party’s losses are greater than the agreed amount of LDs, the clause could be construed as a cap on the breaching party’s liability (unless the agreement expressly states otherwise).
The courts have drawn a distinction between a valid LDs clause and those held to be unenforceable penalties in an abundance of case law. Historically, the clause would be enforceable if it represented a genuine pre-estimate of loss suffered by the non-breaching party. However, the Supreme Court decision in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67 (considered together), rewrote the law on penalty clauses. A clause may be an unenforceable penalty if:
- there is no justification for the clause: i.e. the LDs clause must seek to protect a legitimate interest of the party seeking to rely on the clause, e.g. because the parties agree the provision is commercially justified, or the clause has been agreed by parties with equal bargaining power.
- it is extravagant or unconscionable: the courts will consider this in relation to the interests of the party which the clause in question seeks to protect, i.e. whether the remedy stipulated
in the clause is out of all proportion to the party's legitimate interest in enforcing the other party's obligations under the contract. This will vary on a case-by-case basis and the courts are likely to take a broad view of the matter, including consideration of the contract as a whole as well as the circumstances and context in which the contract was made.
It is worth noting that although the courts have shifted away from the “traditional approach” relating to whether the clause is a genuine pre-estimate of loss, it has not been overruled and may still be relevant / be followed when considering the validity of straightforward LDs clauses.
In summary, LDs clauses need to be drafted carefully. An unenforceable clause may result in a lengthy and expensive damages claim that could, otherwise, have been avoided. Interfacing commercial considerations and legal advice is key to managing this risk for all parties and comes with the advantage of focusing minds on operational risks and contractual clarity to help reduce the risk of such clauses crystallising in the first place.
If you have any questions in relation to the points covered in this update, please contact Hamza Drabu, Carol Sumner or Louise Kane.
