‘Damages’ are money paid, or ordered to be paid, to a person as financial compensation for loss or injury. ‘Liquidated damages’ are an amount of money set out in a contract which must be paid by one party to another if, for example, the other party breaches the contract.
In a recent (9th February 2021) post , we looked at the decision of the Singapore Court of Appeal in the case of Denka v Seraya . This case concerned the test that the court should apply in relation to a liquidated damages clause in a contract to determine whether it was a ‘penalty clause’.
A penalty clause is a clause in a contract which provides for a monetary (financial) payment by one party to another (for example, for a breach of contract), which is not related to the actual loss or harm suffered. Generally, penalty clauses unenforceable. But how does a court decide whether a liquidated damages clause is a penalty clause or not? In other words, what test does the court apply to decide this issue?
In 1915, the House of Lords (now the Supreme Court of the United Kingdom) set down a test in the leading case of Dunlop Pneumatic Tyre Company v New Garage & Motor Company  AC 79. One of the main elements of the test for whether a liquidated damages clause was a penalty clause was whether the liquidated damages was ‘a genuine pre-estimate of loss’. If, for example, the purpose of the liquidated damages clause was effectively to punish the other party for a breach, that would not be a genuine pre-estimate of loss, and therefore the courts would consider it to be a penalty clause, and unenforceable.
However, in 2015, the test changed – at least, under English law. In the leading case of Cavendish Square Holding v El Makdessi  UKSC 67, the Supreme Court of the United Kingdom held that the true test the is that a liquidated damages clause is a penalty only if it was out of proportion to the ‘injured party’s’ “legitimate interests” in the enforcement of the primary obligation under the contract. This might include taking into account wider commercial considerations.
Basically, a ‘primary obligation’ in a contract is an obligation that stands alone. A ‘secondary obligation’ is one that is only triggered if a primary obligation is breached. However, one practical issue that has arisen is the question of whether an obligation is a ‘primary’ obligation or a ‘secondary’ obligation.
In 2017, the English High Court set out some principles on this issue, in the case of Holyoake v Candy  EWHC 3397. In that case, the High Court said the question of whether an obligation was primary or secondary depended on its substance and not its form. The court also said that an obligation under a contract can only be a penalty (and therefore unenforceable) if it is a secondary obligation.
As always, English lawyers will look at these judgments carefully and see how they affect things on a practical level. One of the practical implications of this case is that it now seems clear that if a party to a contract wants to avoid a clause being held to be a penalty clause, then the obligation should be drafted as a primary obligation (and not as a secondary obligation, which is triggered only on breach of a primary obligation). In addition, any secondary obligations must be proportionate to the other party’s interest in the performance of the primary obligation.
In the text above, can you find words or phrases which mean the following (the Answer Key is below)
1. In relation to a contract, a verb that means ‘to break’ it.
2. A noun that refers to someone who is on one side of a contract.
3. An adjective that means that something (for example, a clause in a contract) cannot be enforced by legal compulsion.
4. A phrase which means an important legal judgment which settles an important point of law or legal principle.
5. A phrase meaning to decide a sum of money to be paid, in advance, if a particular event happens.
6. A verb which means to cause something to happen or start.
1. to breach
2. a party
4. a leading case
5. a pre-estimate of loss
6. to trigger
NOTE: The material in this post is intended as study and educational material only. It is not intended to be a definitive statement of the law and it is not to be relied on in any way as legal advice. If you need legal advice, you should always consult an appropriate lawyer.
© Cambridge Legal English Academy 2021