Liqidated Damages & Penalties

Liquidated damages and unenforceable penalties

These charges are not charges for providing services under the contract; they are charges imposed because the customer has breached the terms of the contract. Under contract law, when either party to a contract breaks a term of the contract, the other party is entitled to recover damages for this breach.

They could sue the other party in the courts to recover the damages. As this would not be very sensible for every minor breach of a contract, the law allows parties to a contract to agree in advance what damages would be payable if either party breaks a term of the contract. If the sum payable appears to the courts to be a genuine pre-estimate of the damages that are likely to be incurred, the courts will accept that this sum is what is called liquidated damages and the offending party will be obliged to pay this sum.

However, if the sum specified in the contract is not a genuine pre-estimate of the loss that will be incurred but is excessive and is inserted in terrorem (from Latin, as a warning or deterrent, basically to frighten the other party) the courts call this a “penalty” and will not enforce it.

Therefore, in the case of financial institutions and their customers, the charges made by them because the customer has broken their overdraft limit or not made a payment on time should not exceed the damages that the bank has suffered because of the customer’s breach of contract. If the sum payable is excessive, it will become a penalty and will be unenforceable by the courts.

The damages that the bank suffers if the customer’s overdraft limit has been exceeded are:

a) the customer now owes the bank more than he or she previously did, and, obviously the bank is entitled to recover this amount, but they will do so in due course anyway plus interest (unless the customer defaults all together)

plus:

b) the costs incurred in notifying the customer of the incident. However - does it really cost a bank £20 to send a computer generated, automated letter to the customer to notify them that the account has breached the overdraft limit?

The damages that the bank suffers if they have to return a cheque or direct debit are merely the cost of sending the cheque back to the other bank or notifying them that the direct debit cannot be paid, plus the cost of notifying the offending customer. Does it really cost £30-35 to do these things when these processes are virtually all automated and computer-generated, generally without any human intervention?

It would seem to be very difficult for any bank to justify their charges as being liquidated damages and, as far as we know, there have been no cases where a bank has been prepared to go to court to defend their charges.

The established jurisprudence

The law relating to penalties has been established through case law. The cases date back to the nineteenth century and the courts have been consistent in the way that they have ruled on penalty clauses.

Wilson v. Love (1896)

A tenant farmer agreed to pay an additional rent of £3 per ton by way of penalty for every ton of hay or straw that he sold off the premises during the last 12 months of the tenancy. The clause was regarded as a penalty because at the time hay was worth five shillings a ton more than straw.

Dunlop Pneumatic Tyre Co. Ltd. v. New Garage and Motor Co. Ltd. (1915)

In the particular case, the judges held that the sum specified in the contract was reasonable and was classified as liquidated damages. However, in this case, Lord Dunedin laid down rules which are still applied today in these types of cases:

i) The sum is a penalty if it is greater than the greatest loss which could be suffered from the breach – in other words, if it is "extravagant and unconscionable".

ii) If it agreed that a larger sum shall be payable in default of paying a smaller sum, this is a penalty. Ford Motor Co. v. Armstrong (1915)

In this case, the judges reached the conclusion that the sum to be paid for a breach of the contract was substantial and arbitrary and bore no relation to the potential loss of the other party. It was, therefore, a penalty.

Bridge v. Campbell Discount Co. Ltd. (1962)

In this case a customer bought a car under a hire purchase agreement. He paid the initial and first payments and then cancelled the agreement. The company tried to recover the sums specified in the contract for canceling the agreement, but the courts held that the sums payable were excessive and constituted a penalty clause. It was, therefore, unenforceable.

Murray v. Leisureplay (2004)

Mr Murray was sacked by Leisureplay and he claimed three years' salary as per his contract of employment. The courts decided that this clause was a penalty clause and he was not entitled to this level of damages.

There have been several other cases over the past century. Any good book on contract law or business law will contain references to "penalty clauses", "penalties" or "liquidated damages" cases and a discussion of the law.

See also: Upholding Liquidated Damages & Penalties here