You're negotiating a contract with a business who will supply a product. You really need it by a particular date to profit as much as you hope. So you suggest a 'penalty clause' – if they don't produce on time, they'll have to pay you £1,000 per day late. However, you've heard that penalty clauses aren't enforceable. Is that right?

As shown by a recent High Court case, as long as the penalty isn't out of all proportion to the loss you could suffer, it probably would be enforceable.

The courts distinguish between 'penalty' and 'liquidated damages' clauses. Both cover the possibility of a business breaching the contract, for example by missing a deadline. If that deadline is important, and you expect you'll suffer loss as a result of the delay, you might want to say in the contract how compensation would be calculated. If you don't do that, and the other party misses the deadline, you may have to issue a claim in court and argue about the loss suffered as a result of the breach. That could be a long, difficult and costly process.

That's why businesses use 'liquidated damages' clauses, which set out how compensation will be calculated in specified circumstances. You'll rarely know exactly how much loss will be caused by a specified breach. But if the liquidated damages clause protects a legitimate interest and isn't exorbitant and out of all proportion to the loss you might suffer, it will be enforceable. If the payment doesn't protect a valid interest or is exorbitant, it will be considered a 'penalty clause' and probably won't be enforceable.

It's worth bearing in mind that until 2015 the court applied a slightly different test: is the penalty a genuine pre-estimate of the loss? A 2015 case changed that to the current test (described above), which is broader, meaning more liquidated damages clauses became enforceable.

Confusingly, the most recent case refers to both tests. It doesn't acknowledge a conflict between the 2 or cast doubt on the 2015 case and so it probably doesn't change the law. But one interesting thing about the new case was that the court ruled the clause was enforceable, even though the contract itself described it as a 'penalty'. This is because the court agreed that, regardless of what it was called, it was actually a liquidated damages clause. This was based on all the circumstances, including that in construction contracts liquidated damages are common and the parties were equal in bargaining power, commercially experienced and able to assess the effect of the clause.

You can use liquidated damages clauses when negotiating contracts, but make sure the damages are proportionate and protect a legitimate interest. Although not strictly necessary, you'll be on even safer ground if you make the clause a genuine pre-estimate of your potential loss.

What this means for you

f the other side wishes to insert such a clause don't assume it won't be enforceable, even if it's referred to as a 'penalty' rather than as 'liquidated damages'.

How we can help

Several of our documents have a liquidated damages clause, including our Agreement for the supply of goods (non-retail).