Three Reasons to Agree to Liquidated Damages in Your Commercial Contracts in the UK 

As a business owner, you will negotiate and sign many commercial agreements. Whilst each party to a commercial contract aims to comply with its terms, sometimes it is impossible to avoid a contract breach. In most situations, the other party is owed financial compensation if the contract violation is severe. This article will explore the advantages of providing a liquidated damages figure within your commercial contracts, so your business can consider the merits of doing so.

What is a Commercial Contract?

A commercial agreement is a legally binding contract between two businesses. This can cover all manner of business transactions, whether one party agrees to sell goods to the other in exchange for payment or to provide weekly cleaning services. Some commercial arrangements can be of high value. Thus, any serious contract breach can be costly and lead to financial consequences for the breaching party.

What Are Liquidated Damages?

A liquidated damages clause is where contracting parties set a pre-agreed compensation figure for any serious breach of contract. Naturally, the figure must be reasonable in dissuading the parties from breaching the contract. Likewise, it must not be so high as to stop them from signing the agreement in the first place.

Limiting payment of liquidated damages to specified and severe breaches of contract is imperative.  So, for example, it is common to put them in place for any failure to make relevant payments by a specific date or complete certain deliveries or services by a given date. Let us now consider three advantages of using liquidated damages within your commercial agreements.

1. Promote Certainty

Liquidated damages give the parties advance warning of the financial consequences of a severe contract breach. One of the main difficulties for businesses in the event of a contract violation is determining how much compensation a court would award the innocent party.

A liquidated damages clause gives parties certainty over the likely compensation figure without the need to resort to court proceedings and obtain a judge’s ruling.

2. More Cost-Effective Than Legal Action

For the innocent party, lodging a court action and the progression of the matter to the final hearing to obtain an actual damages figures is an expensive and time-consuming process. A business normally elects to do so to obtain a ruling from a judge regarding the compensation payable by the breaching party.

However, a liquidated damages clause gives the parties the answer to the question should the clause breached fall within the liquidated damages wording. This can therefore save a lot of time, money and stress.

3. Sets a Limit on Compensation

Upon signing the contract, both parties will know the likely maximum compensation payable in case of a serious breach. Whilst no business will want to be in a position where that fee is payable, it is preferable to agree on a cost that will not bankrupt the company rather than an unknown amount.

 So, for example, if a contract states that a business must complete a job by a specific date, it allows the instructing company to warn the other party of the financial implications of failing to do so. Being able to warn of a particular figure for breach of the contract makes it more likely that that business will incur the (smaller) of completing the job rather than facing the (larger) liquidated damages figure. This makes them popular within construction contracts.

Exceptions

Courts will not enforce liquidated damages clauses that set ‘penalty’ figures. This may sound odd as the point of the clause is to place a financial burden on the defaulting party. However, judges only wish to enforce liquidated damages clauses that genuinely attempt to predict likely financial loss to the innocent party rather than stating an absurd figure.

Suppose your business asks a builder to refurbish its restaurant by 1st November. The place is fully booked during November and would make £1,000 profit per day, hence the request. Your business, therefore, wishes to insert a liquidated damages clause.  

If your business inserted liquidated damages provisions awarding £7,000 for each week of non-completion, this would be a genuine estimate of actual loss. It would be unlikely to be struck out by a judge in any future legal action.

However, if your business inserts an arbitrary figure of £250,000, a judge is unlikely to hold this contractual obligation to be enforceable. This is because it could potentially lead to an arbitrary result where the builder completed the job two days late (costing around £2,000) but suffers liquidated damages equivalent to finishing the job nine months late.

Key Takeaways

Liquidated damages clauses are becoming increasingly common within modern commercial contracts.  Put simply, they aid certainty between commercial parties regarding the financial consequences of contract breach, which usually motivates them to avoid contract violations.  However, because English law requires the liquidated damages amount to be a genuine reflection of the likely loss and not a ‘penalty figure’, many business owners obtain legal advice on the figure.

If you need advice on liquidated damages clauses, our experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page. 

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