All successful businesses know that the reason we have contracts is to provide certainty.
A contract sets out what A expects from B, and what B expects from A; and so provides the parties with the benefit of a reference point if expectations are not met – by that I mean when one party is in breach of contract.
When there is a written contract in place, it is often the case that determining whether or not there is a breach of contract is straightforward. And you don’t hear lawyers say that too often!
However, establishing a breach is only half the battle, because in the civil law, a breach acts merely as a trigger for the Courts to then assess whether or not the victim of the breach should be compensated, and if so, by how much.
That assessment is far from straightforward and a great deal of time spent resolving disputes is concentrated on debating whether a victim has suffered a loss as a result of the breach, because, the fundamental objective of the civil law is to compensate the victim, not penalise the perpetrator.
For centuries, contracting parties have tried, and failed, to overcome this problem by inserting clauses in contracts which stipulate exactly what the level of compensation should be in the event of a given breach i.e. failure to do ‘x’ results in a payment of ‘y’. Such clauses were used opportunistically. Parties were inserting sanctions not only to circumnavigate the rigours of having to prove their losses but to impose financial sanctions which bore no sensible correlation to the loss they actually suffered.
By way of illustration, let’s say I agree to pay you £100,000 to build a house for me and we agree a date by when the construction will be complete. If I were to provide in our contract for you to pay me £100,000 for each week’s delay after the completion date, that would be considered as a penalty and unenforceable. Certainly, for each week’s delay I would be without use of the building, but quantifying that use would bring us nowhere near the sum provided.
These clauses became known as penalty clauses and were struck out by the Court when found to undermine the traditional objective of the civil law to compensate the victim rather than penalise the perpetrator.
The Courts have since softened their stance. If the financial sanction included in the contract is considered to be a genuine pre-estimate of loss, the courts will enforce it even if the payment ends up providing for the victim to be paid more than the loss they have actually suffered.
The scenario is perhaps more common place in the entertainment sector, let’s say a venue engages Jose Mourinho to give an after dinner speech and inserts a clause requiring Mourinho to pay £1 million if he doesn’t turn up. This is where the issue becomes more difficult to call – the venue may need to refund tickets, compensate sponsors and even suffer a damage to its reputation.
Such clauses became known as ‘liquidated damages’ clauses. However, the sword is double edged: because liquidated damages clauses can operate to restrict the victim to a fixed level of compensation for a given breach when their losses end up being much higher.
If drafted properly and most importantly if customised to suit your business, liquidated damages clauses are an excellent shield to protect your business.
