When we draft commercial contracts we always need to have an eye on the possibility that one side won’t fulfil the terms of the contract. How is the party that has upheld its side of the agreement to be compensated? A liquidated damages clause will set out in detail the circumstances in which damages will be paid and how they will be calculated when one party defaults. But it’s crucial that these clauses are drafted with precision. If the damages for non-compliance are set at too high a level, or are completely disproportionate to the loss actually suffered by the party that has kept its side of the bargain, they could be classed as ‘penalty clauses’. Penalty provisions like this are unenforceable under English law. That said, as the case of Permavent v Makin (2021) demonstrates, a damages clause can impose an ‘extremely harsh’ sanction without it being deemed an unenforceable penalty clause.
Why Do I Need A Damages Clause?
We’ve seen the importance of clearly defined force majeure clauses in the context of coronavirus. But including provisions for liquidated or fixed sum damages when a contracting party fails to perform its obligations for other reasons is also hugely beneficial. For example, liquidated damages clauses:
- Allow the parties to know exactly where they stand if they default on the terms of the contract
- Remove the need for the innocent party to spend time and money proving actual loss of profits – so the clauses can be relatively straightforward to enforce
Liquidated damages clauses are also helpful in preserving continuing commercial relationships. They enable a breach to be properly compensated without the need for full-blown, acrimonious litigation that cold irreparably damage an existing, profitable partnership.
How Do I Identify A Penalty Clause In A Contract?
When a liquidated damages clause crosses the threshold into the realm of penalty cause it will be unenforceable. So, what is a penalty clause?
The case we rely on for deciding if a clause is an unenforceable penalty clause or not is the Supreme Court case of Makdessi (2015). The question hinges on the following:
- Is the clause a secondary obligation under the contract that’s only engaged when one of the main (primary) obligations of the contract is breached?
- Is the detriment or sanction imposed on the party in breach so ‘unconscionable’ or ‘extravagant’ as being out of all proportion to the innocent party’s legitimate interest in enforcing the primary obligation?
The Makdessi decision was seen as introducing greater amount of flexibility when it came to penalty clauses. Before it if the detriment imposed by the clause was more than a genuine pre estimate of loss it as likely to be viewed as a penalty clause and invalid. In Makdessi however the Supreme Court recognised that there will often be a legitimate interest (patent protection, intellectual property, business goodwill) to protect that exceeds straightforward financial loss.
A Harsh Sanction – But Still Enforceable: The Makin case 2021
In Makin the parties were in business together providing roofing products. They did so through several companies, including one entity called called Permavent. The defendant, Mr Makin had created a product known as ‘Easy Roof System’. Income derived from the sale of the product was a big part of the companies’ profits. When the parties fell out over the running of the business, Mr Makin attempted to stop Permavent from using the Easy Roof System.
Permavent sought an injunction to stop this arguing that the Easy Roof System and the patents belonged to Permavent – not Mr Makin.
Following negotiations the parties reached a settlement under which Mr Makin assigned the intellectual property rights for the Easy Roof System in return for substantial financial payments. Mr Makin agreed that going forward he wouldn’t claim any entitlement to the intellectual property rights over the Easy Roof System. The agreement stated that if he did all payments under the settlement agreement would have to be returned to Permavent, and all sums due under the agreement would be forfeited.
When Mr Makin attempted to register his ownership of some of the rights he had assigned, Permavent sought to invoke the damages clause.
The High Court decided that even though the damages clause was harsh it was nevertheless enforceable (i.e. it did not amount to a penalty clause). First off, Mr Makin had received independent legal advice before entering the settlement agreement so he should have understood the consequences of breaching the commitments he had made. And crucially the clauses didn’t just seek to protect the value of the intellectual property rights – they were an attempt to protect against more widespread damage to the business that might be caused by the actions of Mr Makin. By breaching the settlement agreement, Mr Makin could have potentially prevented Permavent from sourcing, manufacturing – even selling their product.
Contact Nath Solicitors
The cases we’ve mentioned show that damages clauses in contracts raise complex issues. If not drafted with care and a consideration of whether they could be interpreted as penalty clauses they might ultimately be unenforceable. If you would like to discuss commercial contracts contact Shubha Nath at Nath Solicitors on 44 (0) 203 983 8278 or contact us here.
