A trap that contract drafters often fall into is writing a clause that instead of being liquidated damages, crosses the line into a penalty.

In summary the difference is:

• Liquidated damages: If the amount fixed by the parties is a ‘genuine estimate (or pre-estimate as is commonly written) of the loss by a future breach of the contract, it is liquidated damages.
• Penalty: On the other hand if the amount fixed by the parties is unreasonable then it is probably a penalty.

A clause for liquidated damages will require one party to pay the other party compensation for a breach of the contract.  The term “liquidated” means the amount of compensation is either designated or can be accurately calculated.

The amount of compensation that a party should be required to pay, should be a genuine pre-estimate of the loss that would result from a breach of the contract in question.

As opposed to being a genuine pre-estimate, a penalty punishes the party by requiring them to pay a sum that is unconscionable or non-proportional to the loss that would have been suffered.

Some key things to assist in the identification of penalties include:

• the actual effect of the clause rather than the wording of the clause in question;
• whether the clause is a bona fide pre-estimate of (potential) damages;
• the construction of the clause in relation to the context of the contract as a whole; and
• if the payment is of a single amount, whether the amount is proportionate to the breach.

As always expert advice should be sought if you are signing a contract with liquidated damages, or if you are drafting one.