Penalty Clause vs Liquidated Damages
Last updated: February 2025
Quick Comparison
| Aspect | Penalty Clause | Liquidated Damages Clause |
|---|---|---|
| Enforceability | Unenforceable; struck down by courts | Enforceable if genuine pre-estimate or protects legitimate interest |
| Purpose | Punishes the breaching party | Compensates the innocent party |
| Proportionality | Disproportionate to any legitimate interest | Proportionate to the loss or interest being protected |
| Legal test | Fails the Cavendish/ParkingEye test | Passes the Cavendish/ParkingEye test |
What Is a Penalty Clause?
A contractual provision imposing a disproportionate financial consequence for breach that goes beyond legitimate compensation for the innocent party's loss.
Key Features
- • Amount is disproportionate to any legitimate interest in performance
- • Designed to punish rather than compensate
- • Unenforceable under English law following Cavendish/ParkingEye (2015)
- • Courts will refuse to enforce the clause but the rest of the contract stands
Best For
- • Nothing; penalty clauses are unenforceable and should be avoided
What Is a Liquidated Damages Clause?
A contractual provision setting a pre-agreed amount payable on breach, representing a genuine pre-estimate of loss or protecting a legitimate interest.
Key Features
- • Pre-agreed sum payable on specified breach
- • Must be a genuine pre-estimate of loss or protect a legitimate interest
- • Enforceable under English law if not a penalty
- • Provides certainty for both parties about the consequences of breach
Best For
- • Construction contracts with delay damages
- • SLAs with service credits
- • Any contract where actual loss would be difficult to prove
When to Use a Penalty Clause
Never intentionally draft a penalty clause. If a clause is found to be a penalty, it will be unenforceable, leaving the innocent party to prove actual loss through general damages.
When to Use a Liquidated Damages Clause
Use liquidated damages when actual loss from a breach would be difficult to quantify at the time of the dispute. Common in construction (delay damages per day), technology (SLA service credits), and supply contracts (late delivery charges).
Which Does Your Business Need?
Always aim for enforceable liquidated damages. Document how you calculated the amount to demonstrate it is a genuine pre-estimate of loss. Following Cavendish Square Holding v Makdessi (2015), the test is whether the clause is proportionate to any legitimate business interest, not just whether it is a precise pre-estimate of loss.
FAQ
What is the Cavendish/ParkingEye test?
The Supreme Court in Cavendish Square Holding v Makdessi and ParkingEye v Beavis (2015) held that a clause is a penalty if it imposes a detriment out of all proportion to any legitimate interest of the innocent party. The test is not limited to comparing the clause with a pre-estimate of loss; it considers whether there is a legitimate business interest justifying the clause and whether it is proportionate.
Can liquidated damages be challenged even if both parties agreed to them?
Yes. The penalty rule operates regardless of the parties' bargaining power or whether the clause was freely negotiated. However, courts are more likely to uphold a clause negotiated between sophisticated commercial parties at arm's length.
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