In international contracts, parties seek above all predictability and effective control of risk. One of the most powerful contractual mechanisms to achieve both objectives is to include a pre-agreed damages clause, commonly referred to as a liquidated damages or penalty clause. Such provisions fix in advance the sum payable where a party fails to perform a specific contractual obligation. They appear in most international contracts, particularly construction contracts, and are, unsurprisingly, among the most frequently invoked heads of claim in international arbitration.
What Are Liquidated Damages and Penalty Clauses in International Contracts?
Both liquidated damages and penalty clauses (clauses pénales) are a familiar feature of international contracts.[1] They are used routinely across sectors such as sales, construction, finance, and licensing, and often drafted with little distinction between the two. These clauses can apply to many types of contractual breach, including delay, incomplete performance, or defective supply.
A closer look at these clauses shows that they are drafted in many different ways. Their legal nature is often unclear, and it is not always evident whether they are meant to compensate for loss, to penalise breach, or to do both.[2]
A leading commentator on construction contracts, Jane Jenkins, observes that construction contracts “invariably” provide for liquidated damages in the event of late completion.[3] These amounts are typically set on a daily or weekly basis, often include a profit element, and are frequently capped to reflect the contractor’s expected exposure on large projects. In construction, their purpose is twofold: they spare employers the burden of proving delay-related losses (a task that can be complex and highly fact-dependent) and provide contractors with certainty regarding their maximum liability, allowing them to price and manage project risk more effectively.[4] For both parties, they serve as an incentive mechanism that encourages proper performance and timely completion.
Despite their commercial appeal, the enforceability of these clauses depends heavily on the governing law. In common law systems, a strict line is drawn between liquidated damages and penalties, with clauses regarded as punitive being held unenforceable. Civil law systems take a different approach. They generally uphold penalty clauses but allow courts to reduce them if they are excessive.
This divergence can give rise to real uncertainty, particularly in international arbitration. Arbitral tribunals must consider not only how the clause is treated under the applicable law, but also whether they have the power, and the scope, to adjust it.
Key Functions of Liquidated Damages and Penalty Clauses
Despite the different labels used, liquidated damages and penalty clauses perform many of the same core functions:
- First, both types of clauses assess damages in advance, so that the parties know exactly what will be payable if a particular breach occurs. This avoids later disputes about how to value loss or lost opportunities, which can be challenging to calculate, especially in large projects.[5]
- Second, they also reinforce performance. The debtor knows that late completion, non-delivery, or non-compliance will trigger a defined payment, which makes breach less attractive.[6]
- Third, in dispute resolution, the most practical advantage is procedural. Where a valid clause applies, the non-defaulting party does not need to prove actual loss, which saves time and cost. This is especially valuable in arbitration, where expert evidence and document-heavy quantum analysis can dominate proceedings. Even where arbitral tribunals have the power to reduce an excessive clause, published awards show that they often do not require full proof of specific loss in order to exercise that power.[7]
The practical success of these clauses often depends on how carefully they are drafted. Parties are therefore advised to identify clearly the obligations covered by the clause, to consider whether exposure should be capped, particularly in large construction projects, and to specify whether the agreed sum is intended to operate as an exclusive remedy or alongside other contractual remedies. Parties should also take into account that courts or arbitral tribunals in civil law jurisdictions may have statutory powers to reduce the agreed amount.[8]
Liquidated Damages vs Penalties Under Common Law
Common law systems draw a sharp distinction between liquidated damages and penalties, and that distinction has real consequences for enforceability. In jurisdictions such as England, an agreed sum will be upheld only if it is genuinely compensatory in nature. Traditionally, liquidated damages have been described as “a genuine pre-estimate of probable loss”[9] or a “predetermined indemnity”.[10]
A penalty, by contrast, is a sum designed to operate in terrorem of the breaching party.[11] Rather than compensating for loss, it seeks to deter breach by threatening an excessive financial consequence.[12] For that reason, penalty clauses are treated as illegitimate and are unenforceable as a matter of public policy.
Where a clause is characterised as liquidated damages, its effect is straightforward. The non-defaulting party is entitled to the agreed sum regardless of whether its actual loss is higher, lower, or even non-existent. The clause replaces the need for a detailed inquiry into loss and, in practice, operates as a contractual allocation of risk.
While the underlying distinction is common across common law jurisdictions, the way it is applied is not uniform. Until recently, English courts primarily focused on what the parties could reasonably have anticipated at the time the contract was concluded. The question was whether the agreed sum was a genuine attempt to estimate likely loss at that point, assessed ex ante and without the benefit of hindsight. This approach was subsequently modified in 2015, as explained below.
United States courts adopt a more flexible approach. They may consider not only the anticipated loss at the time of contracting but also the actual loss suffered at the time of breach. Both the ex ante and ex post perspectives can therefore be relevant to the analysis. Despite this difference in method, the practical outcome is often similar. Clauses that are grossly disproportionate to reasonably anticipated loss are vulnerable to being struck down as penalties, while clauses that understate potential loss are generally upheld and function as contractual caps on recoverable damages.[13]
Penalty Clauses and Liquidated Damages Under Civil Law
Civil law systems start from a very different premise. Clauses commonly described as penalty clauses or clauses pénales are, in principle, valid and enforceable even where they go beyond pure compensation and include a punitive or deterrent element. Unlike common law courts, civil law courts do not usually ask whether the clause was intended to punish or deter breach.[14] Party autonomy is the starting point, and the agreed sum is generally respected as part of the contractual bargain.
That acceptance, however, is not without limits. In most civil law jurisdictions, courts are given a mandatory statutory power to intervene where the agreed amount is grossly excessive when compared with the loss actually suffered and the circumstances of the case.[15] This power is typically conferred by legislation and cannot be excluded by agreement. While the threshold and conditions for intervention vary from one jurisdiction to another, the underlying logic is the same: penalty clauses are enforceable, but not without judicial control.
Swiss law offers a clear illustration of this model. Articles 160 to 163 of the Swiss Code of Obligations (CO) expressly recognise contractual penalties as valid expressions of party autonomy. As a rule, the creditor is entitled to the agreed sum without having to prove actual loss. At the same time, Swiss courts retain a statutory discretion to reduce a penalty that is considered excessive in light of all the circumstances. That discretion is exercised cautiously and only in exceptional cases, but it is mandatory in nature and is often described as a matter of public policy.[16]
Many Middle Eastern jurisdictions, particularly those influenced by the Egyptian Civil Code, follow the same general framework, though with important variations in application. In some jurisdictions, such as Bahrain, Egypt, Iraq, Kuwait, and Syria, courts may reduce the agreed sum if it is exaggerated or refuse to enforce it altogether where no actual harm is shown. In others, including Jordan, Oman, and the United Arab Emirates, courts may go further and disregard the clause entirely, instead awarding compensation based on proven loss.[17]
In practice, however, these judicial powers are often exercised with restraint. Especially in large commercial and construction disputes, national courts tend to respect the parties’ agreed allocation of risk unless the clause is manifestly disproportionate or abusive.
UNIDROIT, PECL, and UNCITRAL: Agreed Damages in International Arbitration
Despite the sharp divisions that continue to exist at the national level, the main international instruments aimed at harmonising contract law adopt a noticeably more aligned position on agreed damages. Rather than replicating the strict common law distinction between liquidated damages and penalties, these texts favour a pragmatic solution that gives effect to party autonomy while allowing limited intervention where an agreed sum is clearly excessive. This approach has proved particularly influential in international arbitration, where tribunals are often required to resolve disputes that cut across multiple legal traditions.
Article 7.4.13 of the UNIDROIT Principles of International Commercial Contracts recognises the validity of clauses requiring payment of a specified sum upon breach, while expressly empowering tribunals to reduce the agreed amount where it is “grossly excessive” in light of the loss actually suffered and the circumstances of the case. This power applies even if the parties have agreed otherwise, reflecting the mandatory moderation found in many civil law systems.
The Principles of European Contract Law (PECL) adopt an almost identical formulation in Article 9:509. They similarly uphold agreed sums payable upon non-performance regardless of proof of loss, while authorising judicial or arbitral reduction where the amount is excessive.
The UNCITRAL Uniform Rules on Contract Clauses for an Agreed Sum Due upon Failure of Performance (1983) take a more explicit position. Article 1 provides that the aggrieved party is entitled to the agreed sum “whether as a penalty or as compensation”, thereby avoiding the common law distinction altogether. Like the UNIDROIT Principles and the PECL, the UNCITRAL Rules permit reduction where the sum is “substantially disproportionate” to the loss suffered. They are also unique among the harmonised instruments in expressly allowing a claim for additional damages where the actual loss substantially exceeds the agreed amount.
Although arbitral tribunals rarely treat these instruments as binding unless the parties have expressly incorporated them, they are frequently relied upon as persuasive authority. This is particularly so where the clause is unclearly drafted or combines different functions, where the parties have chosen general principles of law or the lex mercatoria as the applicable framework, or where the multi-jurisdictional character of the project makes reliance on a single national law inadequate.[18]
How Arbitral Tribunals Treat Liquidated Damages and Penalty Clauses
In arbitration, the tribunal’s starting point is the governing law of the contract, including any mandatory rules on penalties and liquidated damages. Tribunals do not have a free-standing power to rewrite parties’ agreements simply because they seem harsh. They must follow the approach that a law court applying the applicable law would take.
Where the governing law is English law, arbitrators and courts now apply a slightly revised penalty doctrine following the UK Supreme Court’s judgment in Cavendish Square Holding BV v Talal El Makdessi ([2015] UKSC 67). Traditionally, English law drew a rigid distinction between liquidated damages and penalties based on whether the agreed sum constituted a “genuine pre-estimate of loss” – a formula rooted in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd ([1915] AC 79). Under that old test, clauses that did not reasonably approximate anticipated loss were vulnerable to being treated as unenforceable penalties.
In Cavendish Square Holding BV v Talal El Makdessi, the Supreme Court abandoned the strict pre-estimate requirement and reframed the inquiry around the innocent party’s legitimate commercial interests. The current test asks whether the clause in question is a secondary obligation that imposes a detriment on the breaching party that is “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”. If so, the clause may be treated as a penalty and not enforced. This approach shifts the focus from a mechanical comparison with anticipated loss to a more holistic assessment of whether the clause is commercially justified and proportionate to the interests it protects.[19]
In practice, the legitimate interest test provides common law parties with greater comfort that arbitrators will respect negotiated contractual terms, while still ensuring that clauses that impose an unconscionable or disproportionate detriment will not be upheld. It also means that, in an international arbitration context, tribunals applying English law will look beyond mere loss calculation to the broader commercial interests served by the clause at the time the contract was formed.
Under civil law, arbitral tribunals generally start from the presumption that the agreed sum is valid and enforceable, and focus instead on whether it should be reduced. In doing so, they typically assess whether the amount is clearly disproportionate to the harm suffered, taking into account the circumstances of the breach, the commercial context of the contract, and the role the clause was intended to play in allocating risk or incentivising performance. Factors such as the parties’ sophistication, the nature of the project, and the difficulty of quantifying loss may also be relevant. In practice, tribunals intervene only where the sum is manifestly excessive, treating reduction as an exceptional corrective measure rather than a routine adjustment of the parties’ bargain.
From a practical standpoint, a well-drafted liquidated damages clause can be especially valuable in arbitration. It can turn what would otherwise be a complex, expert-intensive battle over quantum into a more contained discussion about how the clause should be interpreted and whether it is enforceable. Even where tribunals consider reducing an agreed sum, they rarely require full proof of every element of actual loss, provided they have sufficient evidence to judge whether the clause is excessive.
Drafting Liquidated Damages Clauses
Because legal systems take very different approaches to agreed damages, parties who anticipate international arbitration should give careful thought to how these clauses are drafted.
First, the choice of governing law has a direct impact on enforceability. A common law governing law will subject the clause to the penalty rule, but in practice, tribunals applying English law tend to be relatively respectful of clauses agreed between commercially sophisticated parties. Civil law governing laws generally allow greater freedom to include deterrent or sanctioning elements, although courts and tribunals may have mandatory statutory powers to reduce the agreed amount.
Second, where a common law governing law is chosen, it is prudent to make clear that the clause is intended to compensate for anticipated loss and, where possible, to document the basis on which the figure was calculated. Under civil law, parties may wish to acknowledge both compensatory and deterrent functions, while accepting that courts may still reduce the agreed amount.
Third, in construction contracts involving sectional completion or staged handover, liquidated damages should be allocated by reference to individual sections or milestones. A single, uniform rate applied across the entire scope of works is often difficult to justify and is more vulnerable to challenge.
Fourth, agreed damages should sit coherently within the broader liability framework of the contract. Parties should check that the clause aligns with any overall caps on liability and with provisions excluding or limiting certain heads of loss, and should consider stating expressly whether liquidated damages are intended to operate as the exclusive remedy for the relevant breach.
Finally, parties should keep internal records explaining how the agreed figures were derived. Such material may prove helpful in arbitration if the clause is later challenged as excessive, whether under common law penalty analysis or civil law reduction mechanisms.
Conclusion
Liquidated damages and penalty clauses sit at the crossroads of party autonomy, public policy, and procedural efficiency. Common law systems continue to draw a firm line between compensation and punishment, enforcing agreed sums only where they are genuinely compensatory. Civil law systems take a more flexible view, enforcing penalty clauses in principle while reserving the power to step in and reduce them where they go too far.
International arbitral tribunals operate in the space between these approaches. In practice, they tend to follow the governing law and show a strong willingness to respect what the parties have agreed, intervening only where a clause is clearly excessive or conflicts with mandatory rules.
For parties involved in major international projects, particularly in construction and infrastructure, a carefully drafted liquidated damages clause remains one of the most effective ways to allocate risk, limit uncertainty, and bring a measure of predictability to international arbitration.
[1] A.C. Dimolitsa, Chapter 1. Contractual Remedies: Clauses Pénales and Liquidated Damages Clauses, in F. J.M. De Ly and L. Lévy (eds.), ICC Dossier No. 5: Interest, Auxiliary and Alternative Remedies in International Arbitration (2008), pp. 13-14.
[2] Id., p. 14.
[3] J. Jenkins, International Construction Arbitration Law (3rd edn., January 2021), § 2.09[F].
[4] Ibid.
[5] A.C. Dimolitsa, Chapter 1. Contractual Remedies: Clauses Pénales and Liquidated Damages Clauses, in F. J.M. De Ly and L. Lévy (eds.), ICC Dossier No. 5: Interest, Auxiliary and Alternative Remedies in International Arbitration (2008), p. 13.
[6] Ibid.
[7] Id., p. 18.
[8] Id., p. 14.
[9] J. Bailey, Construction Law (2nd edn., 2016), p. 1185.
[10] A. Burr, Delay and Disruption in Construction Contracts (5th edn., 2016), p. 936; see also C. Vasile et al., Chapter 12: Arbitral Practice on Liquidated Damages in Construction Contracts: Focus on Romania, in C. Baltag and C. Vasile (eds.), Construction Arbitration in Central and Eastern Europe: Contemporary Issues (2019), pp. 205-206.
[11] A.C. Dimolitsa, Chapter 1. Contractual Remedies: Clauses Pénales and Liquidated Damages Clauses, in F. J.M. De Ly and L. Lévy (eds.), ICC Dossier No. 5: Interest, Auxiliary and Alternative Remedies in International Arbitration (2008), p. 15.
[12] Ibid.
[13] Ibid.
[14] Ibid.
[15] Ibid.
[16] SFT, decision of 15 March 2007, 133 III 201, cons. 5.2.
[17] See J. A. Chedrawe, Liquidated Damages for Delay in the Middle East: Not Etched in Stone, in N. G. Ziadé (ed.) BCDR International Arbitration Review (May 2017), pp. 99-112.
[18] A.C. Dimolitsa, Chapter 1. Contractual Remedies: Clauses Pénales and Liquidated Damages Clauses, in F. J.M. De Ly and L. Lévy (eds.), ICC Dossier No. 5: Interest, Auxiliary and Alternative Remedies in International Arbitration (2008), pp. 18-21.
[19] Norton Rose Fulbright, Genuine pre-estimate and legitimate interests, April 2016, https://www.nortonrosefulbright.com/en/knowledge/publications/f650a6af/genuine-pre-estimate-and-legitimate-interests (last accessed 12 December 2025).
