Understanding the differences between liquidated damages vs. penalty is an important part of negotiating a construction contract. If the liquidated damages act as a penalty, they cannot be enforced. This means that you will have no way of recovering losses.

Penalty Clauses and Liquidated Damages in Common Law

The purpose of a liquidated damages provision is to calculate how much one party stands to lose if the contract is breached or performance is not delivered. Courts will enforce these provisions if they decide it would be hard to estimate the harm resulting from a broken contract and the damages described in the contract are reasonable, meaning their amount is not more than the actual losses suffered.

The sole purpose of liquidated damages is to provide a method for calculating damages that would be difficult to prove otherwise. When liquidated damages aren't proportionate to the real or anticipated loss, the courts can decide they are a penalty. If the court determines the damages are actually a penalty, the provision will be voided, and the injured party will only be able to pursue actual damages caused by the contract being breached.

There will be minor differences in how jurisdictions will treat liquidated damages provisions. However, in general, there are two important factors which determine if the provision is valid. The first factor is uncertainty, meaning quantifying the potential damage of a breach of contract would be difficult. The second issue is if the damages listed are reasonable and in proportion to the actual harm in question. If the court cannot detect these two elements in the provision, then it will not be enforced.

Most countries will use these same factors to differentiate between liquidated damages and penalties. Countries which use similar rules to the United States include:

  • Canada
  • England
  • Australia
  • Ireland

In India, however, there are no laws that distinguish between penalties and liquidated damages, meaning these damages can be collected even if their intent is to penalize the breaching party.

Civil Law and Liquidated Damages

Countries that use civil law approach view penalties much differently than common law countries such as the United States. Typically, civil codes are based on the Napoleonic Code, which allows contracts to be enforced through the use of penalties.

Recently, civil law countries have attempted to limit the scope of penalties. This allows courts to lower the number of penalties if they decide the original penalty is too large. When the civil code is used, there is usually no separation between provisions for liquidated damages and clauses for penalties.

One way that courts may distinguish penalties and liquidated damages is to examine how they are being used. For example, penalties clauses are generally included in a contract to encourage one party to fulfill their obligations, whereas liquidated damages provisions are used to make sure an injured party is compensated for the harm they have been inflicted.

When using a penalty to encourage contractual performance, there is no need to prove that actual damage has occurred. Penalty clauses that are allowed in civil jurisdictions would not be enforceable as liquidated damages in jurisdictions that use a common law approach. However, while it has long been possible to enforce penalty provisions under civil codes, most courts now have the ability to limit the scope of these penalties.

For example, in 1971, a Resolution on Penalty Clauses was issued by the Council of Europe. The purpose of this resolution was to give member countries a uniform approach for handling penalty provisions. In the resolution, penalty provisions are allowed. However, the courts can reduce the penalty if they find it to be excessive or if they determine the primary obligations of the contract have been fulfilled.

There are several factors the courts can use to decide if the penalties are excessive and should be reduced:

  • Comparing the damages that were estimated to the damages that actually occurred.
  • The interests of both parties named in the contract.
  • The category of the contract and the circumstances that existed when it was entered.
  • If a standard-form contract was used.
  • If the contract breach was made in bad or good faith.

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