The leading case on the distinction between liquidated damages and penalty clauses is Dunlop Pneumatic Tyre Co v New Garage and Motor Co [1915] AC 79. The appellant, Dunlop Pneumatic Tyre Co, sold motor tyre covers to the respondent, New Garage and Motor Co. The respondent contracted not to sell the tyre covers, or offer them for sale, at a price below the appellant's list prices. There was a term in the contract that £5 was payable by the respondent to the appellant for every breach of this agreement. The respondent sold a tyre cover at less than the list price and was sued by the appellant for damages for breach of contract. The House of Lords held that the sum stipulated by the parties was a genuine pre- estimate of the loss which might result and was not a penalty. In the course of giving his speech, Lord Dunedin laid down the following guidance:

• 1. The use by the parties of the words penalty or liquidated damages is not conclusive.
• 2. The essence of a penalty is a payment stipulated as in terrorem (for the purpose of intimidation of the offending party); the essence of liquidated damages is genuine pre-estimate of loss.
• 3. The issue is one of construction of each particular contract, judged at the time of making the contract, and not at the time of the breach. In construing the contract, the following tests may be used:
  • (a) If the sum stipulated is extravagant or unconscionable in amount compared with the greatest loss which could conceivably be proved to have followed from the breach, it is a penalty.
  • (b) If the breach consists only of the non-payment of money, and the sum stipulated is greater, it is a penalty.
  • (c) Where a single lump sum is payable on the occurrence of one or more of several events, some of which may occasion serious and others but trifling loss, there is a presumption that it is a penalty.
  • (d) It is no obstacle to the sum stipulated being a genuine pre-estimate of loss that the consequences of the breach are such as to make precise pre-estimation almost an impossibility.