UK: Global Diversity in the Enforcement of Liquidated Damages

For centuries, business people have been pre-agreeing levels of compensation for breach of their contract. They do this because it helps them to assess the risks involved in the transaction and it simplifies and expedites the resolution of disputes that may arise from non-performance. To varying extents, the jurisprudence of many legal systems supports this behaviour by upholding the agreement of consenting adults.

The differences in approach across different major legal systems offers one very good reason why, where this is legally viable, a considered choice of law selection is important. In any event, the degree of robustness of the courts of any particular jurisdiction on the question of enforceability will go into the mix when assessing general project risk.

Some legal systems rank low on the spectrum of legal certainty in this context. The Civil Code of the United Arab Emirates,¹ for instance, permits a court to adjust a liquidated damages provision to bring it in line with the actual results of the relevant breach. The statute is however silent on whether, and if so, how, this judicial discretion is structured, leaving practitioners to speculate on the likely approach of the local judges.

Chinese Law² gives the people's court and arbitral institutions a similar power of review. If the agreed amount is lower than the loss incurred, the amount may be increased. If the amount is "excessively higher than"³ the loss incurred then there may be an "appropriate reduction". Academic commentators opine that the excessiveness should be determined in light of the actual loss and other circumstances, including difficulties of proof of actual loss and the wilfulness of the breach.

Common Law systems (at least outside of the United States) generally uphold the parties' bargain, except in extreme circumstances. Under the long-serving rule in Dunlop, a decision of the House of Lords, the enforceability issue requires the court to ask whether, at the time the parties entered into the contract, the prime contractual function of the provision was to deter a party from breaking the contract or to compensate the innocent party for breach.

In reality, parties seldom come out and say that they are stipulating a sum (or rate) of liquidated damages primarily as a deterrent, and so courts will look for other indications of the objective purpose of the provision.

In this area, the key issue tends to be just how important it is that the liquidated sum (or rate) is much higher (or lower) than the loss that might be sustained if breach occurred. The Dunlop ruling attributes importance to such a disparity only where the agreed amount is extravagant and unconscionable in comparison with the greatest loss that could conceivable be proved to have followed from the breach. The Singaporean case of Hong Leong Finance Ltd,⁴ illustrates the rule in action. In that case, the Singapore Court of Appeal held that a default interest rate of an extra 11.25% (from 6.75% for the third year onwards increased to 18% after default) was unenforceable under the Dunlop rule. More recently, in the Jeancharm,⁵ case, the English Court of Appeal struck down an annual default interest rate of 260%.

With some consistency, courts in England and other common law jurisdictions, such as Australia,⁶ Hong Kong⁷ and Singapore,⁸ have viewed the existence of such a disparity, i.e. between the liquidated amount and the loss that might be sustained if breach occurred, as relevant but inconclusive. Such a discrepancy does not necessary render the provision unenforceable, since a range of factors interact to determine the basic commercial purpose of the provision.

This is a principle that comes under challenge from time to time. Indeed, in the very recent case of Murray v Leisureplay Plc,⁹ one of a three-member panel of the English Justice Court of Appeal appeared to reinterpret the Dunlop as saying that if parties agree that a party in breach of contract shall pay an unjustifiable amount in the event of a breach of contract, their agreement is to that extent unenforceable. Under this view, a liquidated damages provision would be unenforceable if the basis for calculation was a genuine, yet mistaken, view as to what would be recoverable for the breach at common law. Were this approach to have won the day then business people would need to secure much greater involvement of legal counsel in their commercial negotiations on liability figures. It is a good thing, and not surprising, that the other members of the court did not support this view.

The position remains under English Law that, to be enforceable, the provision must be compensatory rather than deterrent. It is not conclusive of which side of the line the provision falls that the amount stipulated is not an accurate statement of the loss, provided it is not extravagant or unconscionable, having regard to the range of losses that it could reasonably be anticipated it would have to cover at the time the contact was made.

The position in the United States is complicated. Suffice it to say, there is a divergence in the approach of the US courts as to the conclusiveness of a discrepancy.¹⁰ Where United States Law tends to differ from the English Law approach is that courts are encouraged to consider not only the anticipated loss flowing from the breach, at the time the parties enter their contract, but also the actual loss flowing from the breach.¹⁰ In other words, when considering the reasonableness of the provision, the courts will look at the contracting parties' projections at the time of contracting, as well as the ultimate loss and damage sustained by the innocent party. Under the English approach, there is no scope for an after-the-event comparison against the actual results of the relevant breach.