Given the likelihood of small breaches to a contract, it makes good commercial and practical sense to pre-agree the compensation that party A will pay to party B for that breach. These are called liquidated damages:
the paradigm case in which the law of penalties is engaged is where a party agrees that, upon a breach of contract, he will pay the innocent party a sum of money Makdessi v Cavendish, Court of Appeal
‘Liquidated damages’ are agreed compensation at a level set out in the contract (known damages). They make it simpler and quicker to recover losses when party A breaches its obligations. They are not perfect, but the English courts are doing their best to uphold them as ‘available as of right’ without the need for court proceedings.
Typical uses for liquidated damages are:
- construction contracts: the contractor will pay the client agreed damages for breaching the contract by completing the project late, often a fixed sum per week of delay; some contracts allow the client to withhold a percentage of the contract price for failing to provide the programme, collateral warranties or a performance bond, or documents required at completion.
- real estate development contracts: the contractor will pay the client agreed damages for breaching the contract if the works fails to meet a target internal floor area.
- engineering contracts: the contractor will pay the client agreed damages for breaching the contract when the works do not meet required standards of performance, often a percentage of the contract price for that element of the plant.
Also I rarely encounter it in practice, liquidated damages could also be used for failing to comply with certain administrative processes like applying for payment or giving notices of subcontractors.
Defending these damages: the penalty rule
It used to be possible to argue that the level of liquidated damages was a penalty (a principle from banking law) and therefore the client was not able to enforce it. Workers Trust v Dojap explains why it interfered with these type of clauses:
In general a contractual provision which requires one party in the event of his breach of contract to pay or forfeit a sum of money to the other party is unlawful as being a penalty, unless such provision can be justified as being a payment of liquidated damages being a genuine pre-estimate of the loss which the innocent party will incur by reason of the breach.
For years contractors argued that the sums were a penalty and they did not have to pay. Only four cases succeeded. The Supreme Court in ParkingEye v Beavis said this of the rule on penalties:
The penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended.
Any contractor arguing that the liquidated damages are a penalty is likely to get short shrift from the judges. However, it is still possible to defend the claim if the contractor can prove it should have been entitled to an extension of time.
The next post considers lessons from penalties.
For a summary of the law on penalties, the cases discussed above and the current law, see Cavendish Square Holding BV v Talal El Makdessi (Rev 3)  UKSC 67
[Updated July 2018]