Liquidated damages clauses: validity and enforcement

Service page: Commercial contracts lawyer: drafting, review and enforcement.

You signed a contract. You forgot it has a clause that says: “Each day of delay: NIS 3,000.” Now the other side is claiming NIS 90,000 for a month of delay. Will it really get that in court?

As a rule, the clause is valid, but the court may reduce the amount (section 15(a)).

What does Israeli law say?

Section 15 of the Contracts (Remedies for Breach of Contract) Law, 5731-1970 governs liquidated damages in three subsections:

• Subsection (a): if the parties set compensation for a breach in advance, the injured party is entitled to it without having to prove damage. This is the strong point: once there is a breach, the money is due, with no argument over “how much you really lost”. The same subsection also sets the reservation: a court may reduce the compensation if it finds that it was set “without any reasonable relation to the damage that could have been foreseen, when the contract was made, as a probable result of the breach”. Not “a bit high”, but a real gap.
• Subsection (b): an agreement on liquidated damages does not in itself detract from the injured party’s right to claim instead compensation for damage it proves under sections 10 to 14, or from any other remedy for the breach.
• Subsection (c): amounts that the party in breach paid to the injured party before the breach of contract, and that the parties agreed in advance would be forfeited to the injured party, are treated as liquidated damages.

The practical result: the clause works. It saves disputes over the amount of the damage. But it is not “unchallengeable”.

Liquidated damages versus a penalty: what is the relevant difference?

English law draws a sharp line between liquidated damages (an advance estimate of damage, valid) and a penalty clause (a penalty meant to deter, unenforceable). In Israel the law does not make this distinction. Section 15(a) applies to all liquidated damages, and the question is whether the amount was set without any reasonable relation to the damage that could have been foreseen when the contract was made. A “punitive” amount, which is not an estimate of foreseeable damage, is exactly the case the power to reduce is meant for.

In a standard-form contract, even with a business and not only with a consumer, a term that sets unreasonable liquidated damages in favor of the supplier is presumed to be an unfair term (section 4(6a) of the Standard Contracts Law, 5743-1982). A court that finds the term unfair will cancel it or change it to the extent needed to remove the unfairness (section 19(a)).

When will a court reduce the amount?

Not easily. The burden is on whoever asks for the reduction. They need to show that:

• the amount was set without any reasonable relation to the damage that could have been foreseen, when the contract was made, as a probable result of the breach
• the test is based on what could have been foreseen at the time of signing, not on the damage actually caused

A clear example: an amount that has no connection at all to the damage that could have been foreseen (for example, NIS 50,000 for a one-hour delay). On the other hand, when the amount was set in negotiations and the contract explains the basis of the calculation, it is harder to show that it has no reasonable relation to the foreseeable damage.

What should you check if you are asked to pay?

First of all, do not pay and do not ignore it. Make these checks:

• Has the breach actually occurred? The compensation clause applies only to the breach it defines. If the other side reads it broadly, you have an argument.
• Did the other side contribute to the delay? If they delayed handing over information, changed the specification, or caused the delay, this reduces their ability to claim.
• Does force majeure apply? War, a natural disaster, a lockdown: events that could not be foreseen or prevented may release you from the compensation if the contract includes a force majeure clause, or under section 18(a) of the Contracts (Remedies) Law. Where the breach resulted from circumstances that the party in breach, when the contract was made, did not know of and did not have to know of, or did not foresee and did not have to foresee, and could not have prevented, and in which performing the contract is impossible or fundamentally different from what was agreed, the breach is not a ground for enforcement or for compensation.
• Was the amount set “without any reasonable relation” to the foreseeable damage? If, already at the time of signing, damage of that size could not have been foreseen, it is worth considering an application for a reduction.

How do you draft such a clause properly?

If you are the side putting the clause into the contract, a few principles will protect it:

• Anchor it in real damage: state in the contract (even in one sentence) why the amount was set: the average cost of a delay, an expected business loss, the cost of an alternative. This makes it harder to argue that the amount has no “reasonable relation” to the foreseeable damage.
• Set a cap: a clause with no cap looks punitive. “Up to 10% of the contract value” is much better protected than “for each day of delay, without limit”.
• Define the breach exactly: “delay” is not an unambiguous word. How many days? From what date? Including Saturdays? Lack of clarity harms the ability to enforce.