Legal English is often full of impenetrable terms that make contracts unnecessarily difficult to understand. The role of a legal contract should be to make the terms and conditions of any agreement clear and transparent rather than confusing. This article forms part of our series on Legal English and will shed light on some of the major terms and clauses found in legal contracts.

One clause you may often come across is the Liquidated Damages Clause, but what exactly is it?

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In a contract involving two parties, a Liquidated Damages Clause is put into place to serve the best interests of each party and to discourage both parties from breaking the rules of the contract. For example, if Party A fails to uphold their side of the agreement, they must pay a fixed and previously agreed upon sum of money to Party B, who has fully adhered to the agreement.

In this case, Party A is known as the ‘defaulting party’ while Party B is called the ‘non-defaulting party’. Both of these terms will occur frequently in a Liquidated Damages Clause. Importantly, this clause does not aim to punish the defaulting party (Party A) but indeed to compensate the non-defaulting party (Party B).

The courts have developed laws whereby they can control the contents of Liquidated Damages Clauses. The basic rule is: the Liquidated Damages Clause can be enforced if the amount of money to be paid has been estimated prior to the start of the contract, and that this estimate reflects as accurately as possible the loss that would be suffered by the non-defaulting party (the individual or group who sticks to the agreement).

It is important that this estimate is indeed genuine as it will remain fixed in the event that the contract is broken, even if the actual loss suffered is worth more. If the non-defaulting party does actually lose more than originally estimated, they will not be able to sue for their full loss because they are bound to the initial. However, if it is proved that the estimated sum of money was not a genuine reflection of the potential loss suffered, then the non-defaulting party will be able to fully sue for their loss. In this case, the clause would then become known as a ‘penalty clause’. To find out more about penalty clauses read an interesting article in The Student Law Journal entitled ‘Commercial Law’.

One of the principal advantages of this clause is that it helps to avoid uncertainty so it’s really important to master it. It makes each party aware of the consequences that might occur if they do not hold their end of the bargain. Mastering the Liquidated Damages Clause however requires an extended knowledge of Legal English. Undertaking a Legal English course will help you to gain a better understanding of the terminology and specific vocabulary used in contracts or legal documents. The skills and knowledge gained in Legal English will improve your confidence and ability to write contracts or legal documents effectively.

According to case law, there is a presumption that it is a penalty when the clause requires a single lump sum to be paid, on the occurrence of several events, some of which may lead to serious damage and other may result in minor damage. Therefore, when drafting a contract in Legal English, it’s essential to distinguish between serious and minor breaches of contract.

Moreover, a clause will held to be a penalty clause if the amount to be paid is “unconscionable and extravagant” compared with the loss that could be suffered as a result of the breach. Courts however will be reluctant to conclude that a clause is a penalty when it has been agreed by commercial parties who are able to protect their interests.

It’s important to emphasise nevertheless that the function of this clause is to fix the amount that must be paid by the defaulting party regardless of the actual loss suffered by the non-defaulting party. This way, if the loss suffered is greater than the amount set out in the clause, the non-defaulting party is not allowed to ignore the clause and sue for the entirety of the loss.

However, if the amount of damages payable under the clause does not constitute a genuine pre-estimate of loss, it will be considered to be a “penalty clause” and will not be enforceable. The aim of a penalty clause is to punish the defaulting party, which is not permitted under English law. Where a clause is found to be a penalty clause, and thus unenforceable, the non-defaulting party can seek to recover his entire loss even if it is more than that provided for in the contract.

The difference between a liquidated damages clause and a penalty clause is based on the intention of the parties when entering into the contract as well as the date on which the parties entered into the agreement rather than the date of the breach. However, what actually happened after the formation of the contract may be important evidence of what could reasonably be expected to be the amount of the loss.

© Communicaid Group Ltd. 2011