The Price of Non-Performance: Structuring Service Credits and Liquidated Damages After the Penalty Rule

When a service falls below the agreed level, or a deliverable arrives late, the contract is expected to do more than record the failure. It must supply a remedy that is usable, proportionate and enforceable. In 2026, as outsourcing, SaaS and supply arrangements become more outcome-focused, service credits and liquidated damages remain the two most common tools. Yet they are frequently drafted as if the label alone determines their legal character. It does not.

The penalty rule continues to matter. The Supreme Court's decision in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis clarified the modern test, but it did not remove the risk. A provision may be unenforceable if it imposes a secondary obligation with a detriment out of all proportion to the innocent party's legitimate interest in performance. Drafters therefore need to think about purpose, measurement and proportionality before they reach for a percentage.

Service credits as price adjustments

Service credits are often best understood as a reduction in price for a service that has been delivered below the promised standard. If availability falls, response times slip or resolution targets are missed, the customer receives less than it bargained for. A credit that adjusts the charges for the affected service can reflect that reduced value without pretending to be a full assessment of consequential loss.

That characterisation is commercially useful, but it is not conclusive. A credit regime can still be vulnerable if it is calibrated to deter rather than to reflect reduced value. A modest credit tied to a defined service level is unlikely to be treated as penal. A regime that imposes a large fixed sum for a minor administrative failure, or that escalates sharply without any connection to the value of the affected service, invites scrutiny.

The drafting should make the connection explicit. Credits should be calculated by reference to the charges for the affected service, not the whole contract value. They should be subject to a clear aggregate cap. They should distinguish between service level failures that are within the supplier's control and those caused by the customer, third-party dependencies or agreed exceptions. The language should describe the credit as a price adjustment, not as a punishment.

Liquidated damages and the genuine pre-estimate

Liquidated damages serve a different function. They are usually a contractual estimate of the loss that will flow from a specified breach, such as delay in delivery or failure to achieve a milestone. The modern test is not simply whether the sum is a genuine pre-estimate of loss, but whether the clause is penal in substance. Evidence that the parties made a reasonable assessment of likely loss at the time of contracting remains highly relevant.

A court will not require mathematical precision. Commercial parties are allowed to agree a formula that is workable, even where the actual loss will vary. What matters is that the formula has a rational connection to the legitimate interest protected by the contract. If the sum is extravagant, imposes a sanction unrelated to any likely loss, or operates as a deterrent to breach rather than compensation for it, the clause may fail.

For delay damages, the formula should identify the affected deliverable or service, the rate per day or week, the start date, the trigger for cessation and an overall cap. The recitals or an accompanying schedule can explain the losses the parties had in mind: lost use, additional management costs, replacement costs or disruption to downstream operations. That explanation is not decisive, but it helps to show that the figure was not pulled from the air.

Common drafting errors in 2026 contracts

Several recurring errors make remedies vulnerable.

• Stacking remedies without election. A contract may provide service credits, liquidated damages, termination rights and general damages for the same failure. If the customer can recover all of them without limitation, the total detriment may look disproportionate. The contract should state which remedies are exclusive, which are cumulative and how caps interact.
• Using total contract value as the credit base. A failure affecting one service line should not usually generate credits calculated on the entire agreement. The credit base should match the affected service or deliverable.
• Escalating multiples with no loss rationale. Doubling or trebling credits after repeated failures may be commercially attractive, but it can look punitive if the increase is not tied to the customer's likely loss or legitimate interest in reliable performance.
• Ignoring causation and exceptions. Remedies should not be triggered by failures caused by the customer, approved changes, third-party platforms outside the supplier's control or agreed maintenance windows.
• Mislabeling. Calling a provision a service credit does not prevent a court from treating it as a penalty. Calling it liquidated damages does not make it a genuine estimate.
• No aggregate cap. An uncapped credit or damages regime is not automatically penal, but it increases the risk of a disproportionate overall detriment. A cap, combined with termination rights for persistent failure, often gives the customer adequate protection.

Clause language that ties remedy to loss

A service credit clause might provide:

Where the Supplier fails to meet an Availability Commitment for a Service in a calendar month, the Charges for that Service shall be reduced by 5% of the monthly Charges for the affected Service for each full 0.1 percentage point below the Availability Commitment, subject to an aggregate cap of 20% of the monthly Charges for that Service. The parties agree that this credit is a price adjustment reflecting the reduced value of the affected Service and is not a penalty. It is the Customer's sole financial remedy for the relevant Service Level Failure, without prejudice to termination for persistent failure or remedies for breach unrelated to that failure.

A liquidated damages clause might provide:

If the Supplier fails to deliver a Deliverable by the Delivery Date, the Supplier shall pay liquidated damages of 0.5% of the Charges for the affected Deliverable for each day of delay, up to a maximum of 10% of those Charges. The parties agree that this sum is a genuine pre-estimate of the Customer's loss arising from delay, including loss of use and additional administrative costs. Liquidated damages are the Customer's sole remedy for delay, but do not limit remedies for defects or other breaches.

These clauses are not templates to be copied without adjustment. They illustrate the discipline required: a defined trigger, a measured base, a cap, an explanation of purpose and a clear relationship with other remedies.

A practical checklist

Before signing, ask whether each remedy is linked to a service or deliverable the customer actually values; whether the rate reflects reduced value or likely loss; whether the cap is proportionate; whether exclusions and causation are clear; and whether the interaction with termination and general damages has been thought through. A remedy that cannot be explained in commercial terms is more likely to be challenged in legal terms.

The penalty rule does not prevent parties from agreeing robust remedies. It requires them to distinguish between compensation for non-performance and a sanction for breach. In 2026, that distinction is not a drafting nicety. It is the difference between a remedy that can be relied on and one that invites a dispute.