Lawyers react to penalties about as well as the England football team in a World Cup year; we just don't like them.
In a contract, a penalty clause is a term which provides for a fixed payment on breach, the purpose of which is to discourage contract breach. As a general rule, penalty clauses aren't enforceable in the UK if they are clearly intended to be a disincentive to breach.
The most frequent area where this issue arises is in relation to "liquidated damages" clauses in contracts, under which a supplier is required to pay a fixed sum for every week or month of delay in delivery of a contracted system. They are used as a short-cut to avoid long-winded court claims for the cost and effect of late delivery by a supplier – which can often be hard to establish with certainty. Most often, an LDs clause can be spotted by the characteristic use of the words "... that the parties agree is a 'genuine pre-estimate of loss'," which is lawyer shorthand for "we don't want this to be ruled a penalty".
Actually, the genuine pre-estimate of loss test isn't the only one which may justify a clause that specifies a set level of payment. If there is sufficient "commercial justification" for a clause, it may be held not to be a penalty even if the compensation sum is chosen by a distinctly unscientific method.
And therein lies the main problem with liquidated damages clauses; no one really knows how to set the right amount. There's no clear legal precedent for that; the best the courts say is that it depends on the facts and, if the main purpose of a clause is to deter the other party from breaching the contract, it will be unenforceable as a penalty clause.
My usual starting point is an equation using a percentage of the contract charge and the number of weeks of lateness before non-delivery has a really significant adverse effect for the customer. After that point, all bets should be off and the customer would have the right to terminate the contract and claim actual loss. But, until that point, LDs can accrue up – probably as an exclusive remedy – to a total somewhere between 10% and 20% of the price.
Interestingly, the general attitude of the British courts is that they are reluctant to characterise a clause negotiated between commercial parties as a penalty, especially where negotiated by parties of equal bargaining power. So there can be a reasonable degree of latitude to negotiate on the amount of LDs.
But having started with football, I'll end with it. Some of the most recent law in this area was made by Henning Berg, the manager sacked by Blackburn Rovers after less than two months in charge. Under his contract, he was due £2.25 million in compensation for his sacking, which Blackburn argued was a penalty. Sorry, the court said, the law on penalties doesn't apply where the trigger for payment is not a breach of contract. So, for example, where a party seeks to maintain flexibility to terminate for convenience and has agreed to pay compensation, the penalties rule doesn't apply. If only FIFA would take the same approach and ban penalties for the World Cup, England might stand a better chance of success.