Suppose that you were running a network mobile company and that we are your customers. You offer an all-in deal. Customers are tied into your service for a period of months and get a new mobile phone thrown in. Your business involves a multitude of contracts with individual customers where there is always a risk that your customers will breach the contract, usually through failing to pay or trying to walk away from the contract.

Your phone company has a number of costs – it has had to set up and maintain its network, it has had to buy the phone. You would know that fixing in advance the amount that you would receive would give you certainty. Further, fixing that amount would enable you to make sure that you covered your losses. So, to protect yourself, you have a liquidated damages clause put into the contract. This sets out how much your customer will have to pay you if they breach their contract with you.

This need not be as one sided as it may seem. If we get good deals on a mobile phone airtime contract, with the phones thrown in, we couldn’t expect just to hand the phones back and walk away from the contract whenever we feel like it without at least making sure that your company covered its costs and made a basic profit. If we could walk away, in future the good offers would dry up. Then we would have to pay all of the costs up-front or have to get by without being able to use a mobile network. We accept that if we have entered into a contract with you we can expect to have some obligations and it would probably suit us to be able to pay on a monthly basis rather than having to find the money for an up-front payment. So there is nothing inherently wrong with the idea of being expected to pay for things we have received under a contract or having to compensate you if we want to break our contract with you.

If you are upfront with your customers then they can tell what it will cost them to break their contract with you if, for example, better contractual offers come our way. , That matters because we are then free to compare the cost of breaching our contract with you with the benefits that will accrue to us from getting new phones from another company. We can make an informed decision.

Of course that raises the tricky question of how much we should have to pay if we fail to live up to our contractual obligations. We ought to have to pay you the amount of your loss and no more. But what could we do if you decided to fix the contractual damages at a higher level than your real loss? We could argue that your ‘liquidated damages clause’ was in truth a ‘penalty’ and that you should only be able to recover your true loss.

It isn’t always easy to work out when a clause might be a penalty. The four stage test Dunlop Pneumatic Tyre Co Ltd v Dunlop Motor Co Ltd [1907] A.C. 430 has produced real problems in a commercial context.

In our next blog entry we are going to look at how the Supreme Court has taken a fresh look at the topic of penalty clauses and come up with some surprising results. In the case of ParkingEye Limited v Beavis  [2015] UKSC 67, the Supreme Court went back to Dunlop, dug into it and, engaging in a little creative archaeology, ‘discovered’ a suitable way of applying the rule against penalties in commercial cases.