The validity of liquidated damages clauses in the UK and Bulgarian jurisdictions25th August 2021
A liquidated damages clause is a contractual provision requiring a party to pay a genuinely pre-estimated and agreed amount in the event of a specified breach. The purpose is to compensate the injured contract party for the breach.
The inclusion of such a clause has the benefit of saving unnecessary costs and time for determining the compensation post-facto, especially where such a cost is difficult to quantify.
However, the convenience of using such provisions could be significantly undermined if they are stricken down as unenforceable and, hence, they should be carefully drafted. In the following note, we outline the law on the enforceability of agreed damages clauses in Bulgaria, comparing to the well-known common law system of England and Wales.
While this note is likely to be of interest mainly to lawyers (both general counsel of corporations and lawyers in international private practice), it may be of some interest directly to a general business audience.
Liquidated damages vs penalties – the English law stance
In England and Wales, a liquidated damages clause could be invalidated if it is not a genuine pre-estimate of loss, but rather a penalty. A penalty clause, according to English law, is a clause that sets predetermined damages which are out of proportion to the legitimate interest of the innocent party.
A clause might be held to be a penalty, and therefore unenforceable, if the stipulated sum is extravagant and unconscionable when compared to the greatest loss that could conceivably follow from the breach. For instance, a clause is likely to be penal if the breach in question consists solely in the non-payment of a sum of money, and the liquidated damages stipulated are a sum greater than the sum that ought to have been paid (accounting perhaps for a normal economic rate of interest, too).
Nevertheless, the impossibility to precisely pre-estimate the consequences of the breach does not prevent the stipulated sum from being a genuine pre-estimate of loss. If the liquidated damages can be commercially justified and seem reasonable and proportionate on the face of the contract as a whole, the question of their validity would rarely be successfully disputed.
As a matter of construction, a liquidated damages clause should be specific enough so that it is clear when to pay and how much. Nevertheless, there is no express requirement to fix a specified number. The payable sum can be determined eg by a formula, which could be a simple arithmetic calculation or a more complex one. However, if the sum is not fixed, or is difficult to calculate, there is a risk that the court will strike down the liquidated damages clause as void for uncertainty.
Therefore, issues with the estimation of the precise sum payable under a liquidated damages clause could be mitigated by:
- Introducing a cap on the specified liquidated damages. Such a cap might prove useful where the sum payable is to be calculated by a reference to an asset the value of which is likely to change over time, to avoid the risk of the clause being stricken down as penal in the event of the asset value becoming disproportionally high.
- Explain in detail the contract, including how the parties arrived at the figure and the factors taken under consideration in calculating.
- There should ideally be a detailed commercial justification for the figures.
- Absent some or all of the above, keeping a (contemporaneous) record of the negotiation of, and agreement on the liquidated damages sum for the avoidance of doubt.
The law in Bulgaria on contractual penalties
The Bulgarian law does not distinguish clearly between a legitimate liquidated damages clause and a penalty clause. Instead, both types of clauses are treated as a contractual penalty (‘неустойка’) which compensates the innocent party and secures performance, without the need to prove the damages. As in England, the innocent party is able to claim additional compensation for loss or damages above the contractual penalty, which must be proven.
Under Bulgarian law, there are generally three functions a contractual penalty might have:
- Preventative – to secure the performance of an obligation;
- Compensatory – to provide compensation for the losses and/or damages suffered by the innocent party in event of breach; and/or
- Punitive – to punish the party in breach.
Unlike the liquidated damages in the UK, Bulgarian contractual penalties will be upheld even if punitive, rather than purely compensatory. However, if the only object of a liquidated damages/penalty clause is punitive, it may be declared void.
There are also the following general types of contractual penalty:
- The standard one: owed upon breach, but additional compensation can be sought for greater damages actually suffered;
- Alternative: where the creditor can choose between penalty and compensation for damages;
- Cumulative (or also ‘punitive’): where the debtor owes both the penalty and compensation for damages regardless of their actual amount;
- Exclusive: where only the penalty is owed regardless of whether the actual damages are greater or lower;
- Potential: owed only where the actual damages exceed a certain amount.
The court might take the actual loss into account when using its discretion to reduce the agreed penalty in so-called civil contracts (i.e., not ones among undertakings recognized as commercial). A contractual penalty in a civil contract could be reduced, but not entirely and only upon application by the defendant, for the following reasons:
- If the stipulated sum drastically exceeds the loss suffered; or
- If the breach is only partial, i.e., if the other party has performed a part of their contractual obligations.
The onus is on the defendant to prove that the above conditions are met. Cumulative penalties cannot be reduced on grounds of being excessive.
In commercial contracts (i.e., ones among commercial undertakings only – which may include individuals contracting in the course of business), the contractual penalty cannot be reduced by the court on grounds of being excessive. However, a court or an arbitrator could render such a clause unenforceable by declaring it ‘null and void’, for example, where the clause is deemed to not fit within the three functions as mentioned above, or reduce it where, for example, the claimant’s acts or omissions contributed to the breach.
Given the wide discretion under Bulgarian law to define the function and amount of the penalty, it may be useful to agree on a cap or a limit on the liquidated damages. Thus, one might eliminate the risk of their clause being stricken down or reduced (in particular, in civil contracts).
Liquidated damages clauses provide an easy way for the parties to a contract to negotiate in advance a proper compensation in the case of a default or breach of contract. Therefore, it is worth paying attention to the requirements in the different jurisdictions to avoid the possibility of such a clause being held unenforceable.
Under UK law a liquidated damages clause cannot be enforced if the same is held to be a penalty or void for uncertainty.
In contrast, Bulgarian law permits the punitive function of contractual penalties, alongside with two other functions – preventative and compensatory. However, Bulgarian courts can strike down contractual penalties if they fall outside of the three permitted functions, or, in certain circumstances, reduce the amount payable considering, among other things, the loss suffered by the innocent party.