When is a termination payment a penalty?

The courts are frequently asked to determine whether a clause providing for payment of a fixed sum on breach of contract is a penalty (and unenforceable under English law) or a genuine pre-estimate of loss (‘liquidated damages’), in which case the clause will be enforceable. The approach of the courts can be summarised as: ‘Whether a provision is to be treated as a penalty is a matter of construction to be resolved by asking whether, at the time that the contract was entered into, the predominant contractual function of the provision was to deter a party from breaking the contract or to compensate the innocent party for breach. That the contractual function is deterrent rather than compensatory can be deduced by comparing the amount that would be payable on breach with the loss that might be sustained if breach occurred.’

An important point to bear in mind with penalty clauses — often forgotten — is that the rule against penalty clauses only applies where there is a breach of contract. If the trigger event is not a breach, then the payment (which will be a debt rather than damages) cannot be an unlawful penalty…

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