Introduction

This note, dealing with liquidated damages and penalty clauses, is the second addition to a series comparing civil and common law approaches to commonly encountered problems in international disputes.

Our current topic is highly relevant in international disputes where the enforceability of penalty and liquidated damages clauses may depend on whether common law or continental law is applied to the dispute.

Following the structure of our previous post (on diverging approaches to disclosure obligations in disputes), we will compare the approach applied towards liquidated damages and penalty clauses by the law of England and Wales, on the common law side, and the law of Hungary, on the civil law side.

Liquidated damages and penalty clauses are both contractual provisions that allow parties to agree on a fixed sum payable in damages upon breach. The common law notion is closely tied to actual damages incurred, whereas the civil law approach is more closely related to the act of breach itself.

Thus, the two traditions apply a different starting point, but at their core, both solutions seek to offer proportionate compensation for an injured party if the sanctity of a contract is breached. This is a delicate balancing act which is at first left to the parties at the formation of the contract. If there is a dispute pertaining to the liquidated damages or penalty provisions, parties may turn to the courts or arbitral tribunals who are then required to find balance between the breach of the contract and the damage. It is in this balancing act that we can see the difference between the two traditions. Common law systems focus on the damage, civil law systems focus on the breach: the first will strive to apply compensation equal to the damage, while the latter wishes to compensate for the fact that a party did not comply with their contractual obligations.

While differences in legal traditions’ approaches to liquidated damages and penalty clauses may seem subtle, the practical effect of a decision to uphold or reject the validity of such clauses will be of great consequence to the parties in dispute. Business players, unlike lawyers, focus not just on the fairness of the penalty for a contract breach but also on the ‘promise’ of a penalty serving as a powerful signal during negotiations. The weight of this signal increases with the size of the promised penalty. However, a higher penalty also risks judicial review in many legal systems, highlighting a key discrepancy. While lawyers concentrate on post-breach scenarios, business players tend to focus on the pre-contractual phase. For this reason, it is crucial for practitioners from various legal backgrounds who will be asked to argue and assess the validity of these clauses, to be equally familiar with the divergent approaches taken by continental and common law traditions.

The English Law Approach

English law is considered to be a traditionally commercial-facing regime, its contract law is widely relied on and applied around the globe. In recognition of the commercial realities of complex contractual systems, liquidated damages clauses are permitted by the law of England and Wales; however, ample case law exists to keep the exercise of the mechanism fair and reasonable. The revisionary control exercised by the courts over liquidated damages clauses is informed by, among others, the principles of freedom of contract and sanctity of contract on the one hand, and the general approach taken by English law towards the award of damages, on the other.

Put simply, under English law, parties are generally free to agree on the terms of a contract and allocate the risk amongst themselves, as they see fit. Further, while some regimes (e.g., US law) are more open to the concept of efficient breach of contract, English law values the finality of contractual agreements and maintains that they are created to be performed. It follows from these principles that parties are free to apportion the risk by agreeing on a fixed sum of damages, and there is value in the clause’s cautioning and deterrent effect.

These considerations must of course be balanced against the principles behind awarding damages. The purpose of awarding damages in English contract law is to compensate the injured party, not to penalise the party in breach. While US law is more generous in awarding damages, English law is overwhelmingly compensatory, and punitive damages are not permissible under contract law. Additionally, a point must be said for personal freedom; while parties are allowed to enter into agreements as they wish, the courts may exercise control over contracts which are deemed to be too onerous.

Several tests for determining whether a provision is a legitimate liquidated damages clause or a penalty clause, have been developed by the courts over the years, all generally assessing whether the burden imposed by the clause is proportionate to a genuine estimate of loss that would arise out of a future breach.

While these tests may still occasionally inform the courts, the “true test” was summarised by the Supreme Court in the case of Cavendish Square Holdings BV v Talal El Makdessi.

In Cavendish, the Supreme Court outlined the following pertinent points:

• Liquidated damages clauses are not standalone provisions, they are secondary obligations, i.e., their operation is “brought to life” by the breach of a primary obligation.

• Courts must have regard to the relevant circumstances of the agreement, including its commercial background, the relation between the parties, as well as the parties’ nature. An enquiry under such points will look at whether it was created between experienced commercial parties, and whether they were dealing at arm’s length.

• Courts must first assess whether the clause is aimed at protecting a legitimate interest of the innocent party in having the contract performed. What a legitimate interest may be is not clearly defined, however, if there is an element of reliance from the innocent party (for example, their performance of another contract hinges on the correct performance of the contract in question) will likely fulfill the requirement. 

• Courts must then, having regard to this legitimate interest, examine whether the clause imposes an “exorbitant or unconscionable” obligation. This aspect of the test includes some form of a proportionality review. By way of example, it is indicative of a penalty clause if a party is obliged to pay the same amount in fees for breaches of various seriousness and consequence.

While liquidated damages clauses often concern a fixed sum payable upon breach, other arrangements, such as forfeiture of deposits or transfer of assets at an undervalue, are also subjected to the test described above.

If a court considers a clause to be penal in nature, that clause will become unenforceable against the party in breach. The practical consequence of this determination is that while the injured party may still have a remedy against the wrongdoer, they must obtain a remedy via settlement or pursue a claim for damages, where the damages will be assessed by the court. 

The Hungarian Law Approach

The civil law approach to liquidated damages, typically encapsulated as contractual penalties, provides a slight contrast to that of common law jurisdictions. Unlike the latter, civil law focuses more on averting and discouraging potential contractual breaches rather than providing a pre-agreed shortcut solution for compensation of damages. Penalties in civil law primarily function as deterrents, establishing a framework of payment obligations should contract performance be compromised.

This preventive aspect is intrinsic to penalty rules, as the obligation to pay the penalty is more directly connected to the contractual breach itself, rather than the damages the aggrieved party might have suffered. In other words, it’s the breach of the contract that triggers the payment obligation, not the occurrence of damages.

Under Hungarian law, three aspects of the penalty clause system stand out. First, in the event of a contractual breach, the obligation to pay the penalty arises, irrespective of the presence or absence of actual damages. Second, should the penalty fail to fully compensate the loss incurred, the aggrieved party retains the right to seek additional damages concurrently with the penalty. Third, a party suffering damages maintains the right to claim compensation even if they have not previously sought the payment of the penalty. Penalties may be linked to defective or late performance, as well as complete non-performance. Parties are free to agree if these penalties should be cumulative in nature, how they should be calculated and obviously how much they should be.

This, of course, is not without limitations. True to its civil law core, the Hungarian Civil Code allows for the courts to reduce penalties deemed excessive upon request. The responsibility of defining what constitutes ‘excessive’ or ‘manifestly excessive’ has fallen to the courts. In Hungary, the guiding principle when moderating the penalty is proportionality, taking into consideration objective factors such as damage caused and subjective elements like the degree of fault, as well as the parties’ circumstances.

Notably, the term ‘excessive’ is used primarily as a measure but isn’t the only determinant. Other factors, such as the extent of fault, the value of the service provided, and the penalty amount, are considered as well. Latest court decisions (BDT 2012.2706) indicate that the courts take into consideration even more factors, including: the relationship between the service’s value and the penalty amount; the circumstances surrounding the contract’s formation, particularly the feasibility of performance when the contract was signed; any potential contract breach by the injured party; the claimant’s interest in performance as well as the financial standing of the parties. In other words, courts may consider other circumstances deemed pertinent in relation to penalty reduction on a case by case basis. However, some rules of thumb do emerge: penalty for non-performance rates highest on the scale, courts acknowledging the highest amount for such breaches. (BDT 2012.2709.)  Generally, if there is no limit for delayed performance, the penalty is considered excessive. (Pfv.21.568/2011/4.). Hungarian arbitral tribunals follow the established court practice in reduction of excessive penalties and are mindful to remain within the request presented by the party (MKIK 2/8/2019)

Even though these limitations are applicable, courts demonstrate reasonable restraint in intervening in parties’ relations and are cautious to establish whether reduction is justified.

Conclusion

Even though the interpretation and enforcement of liquidated damages clauses seem to be converging towards a more uniform approach globally, their application still differs between common law and civil law jurisdictions.

In common law jurisdictions, a contractual clause imposing penalties for non-compliance or breach will typically not be upheld if it’s not reasonably related to the actual or anticipated damage, or if it’s intended to penalize the defaulting party. Liquidated damages clauses are according to the common law concepts pre-estimates for losses, and should remain tied to the sum of damages. It is indeed a shortcut to get compensation for losses.

Conversely, in civil law jurisdictions, the baseline assumption is that penalty clauses are enforceable and they serve to penalize the breaching party for its non-compliance, even if there is no actual damage, although its quantum may be reduced if it is deemed excessively high. Unlike the common law approach, which focuses on estimating actual damages, civil law jurisdictions primarily consider this as just one among many factors when assessing whether a penalty is “excessive.”  Penalty clauses are fixed remedies for breach of contract, which are expressed in payable sums.

While the difference between the two regimes requires careful consideration at the formation of the contract and then, before the courts and tribunals as well, in their essence they are actually very similar. Such clauses are included in contracts to serve two functions: first, they allow the injured party to swiftly receive compensation from the party in breach, without the need to determine the actual extent of damages via lengthy dispute resolution proceedings. The second effect is the deterrence of breach – a factor which is often subject to scrutiny under different legal systems.

Thus, while the reading and interpretation of the same contract may differ under a common law and civil law regime, it is quite possible that the conclusion will be very similar, if not the same. Much like taking the same road, but driving either on the right or left side.

by Petra Pataki and Lili Hanna Fehér