Parties to a contract can agree in advance on the amount of damages that must be paid if either breaches the contract. This can avoid the need to go to court to work out the amount due if a breach occurs. If the agreed amount represents a genuine estimate of the likely loss, the courts will enforce the clause. The agreed amount must be paid even if the real loss is more or less than that.
However, if the amount specified in the contract is not a genuine estimate of the value of the loss, but is only a threat to make the other party perform the contract (that is, a penalty), it will not apply. Instead, the court will work out the actual value of the loss that must be paid.
Disputes often occur about whether the amount stated in the contract is a penalty or a genuine estimate. The court uses the following principles in working this out:
- it does not matter what the contract calls the sum. The court will make up its own mind about whether it is a penalty or not
- if the sum is obviously a lot more than the real loss which could result from a breach, it is likely to be a penalty
- if there are lots of possible breaches of contract, which could produce different amounts of loss, but only one sum is provided for breach of contract, that is probably a penalty.
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