In a judgment of some significance, the doctrine of penalty clauses has been re-cast by the Supreme Court in the case of Cavendish Square v Makdessi; ParkingEye Limited v Beavis. These cases (which are discussed in more detail in our
related post here) are not construction cases. Nevertheless, the Supreme Court’s judgment has seemingly made it much harder to successfully claim that a liquidated damages provision is unenforceable as a penalty.
Interestingly, the court had given serious consideration to whether the doctrine should be abolished altogether describing it as “an ancient haphazardly constructed edifice which has not weathered well…” and doubted whether the rule would have been invented in the modern day. However, the Supreme Court decided that the doctrine should remain due to its long standing nature and many of the criticisms of the principle are “better addressed by taking a principled approach to the interests that may properly be protected by the terms of the parties’ agreement“.
The old test for penalty clauses
The long-standing law on penalty clauses derives from Lord Dunedin’s judgment in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd . The test had traditionally been expressed as being a dichotomy between compensatory and deterrent clauses. To that end, the concepts of genuine pre-estimates of loss and deterrence were fundamental to the doctrine of penalties.
The new test for penalty clauses
While there has been some erosion into the doctrine over the years (e.g. the Court of Appeal decisions in Lordsvale Finance v Bank of Zambia and Cine Bes v United International Pictures), the Supreme Court noted that Lord Dunedin’s tests had achieved “the status of a quasi-statutory code”. All 7 judges in the Supreme Court took the view that Lord Dunedin’s judgment has been given too much emphasis in later authorities.
The court considered that the doctrine was being interpreted in too narrow a manner. The legitimacy of the clause is not to be judged solely by the damages that would have been awarded by a court. In a significant re-statement of the law, it held that the fact the clause was not a genuine pre estimate of the loss did not mean that the clause was unenforceable.
Instead, Lord Neuberger and Lord Sumption cast a new test to be satisfied:
If a provision, which is a secondary obligation, imposes a detriment on a party in breach which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation then it will be a penalty clause and unenforceable.
Lord Mance used slightly different wording to express the test, focussing on whether the detriment is, in the circumstances, “extravagant, exorbitant or unconscionable.” There may be some uncertainty as to whether this means exactly the same as “out of all proportion“, although the fact that Lord Hodge used both terms in his casting of the test suggests that the two terms should in practice amount to the same thing.
In explaining the application of the test, Lord Mance considered that the court would need to consider the extent to which the parties were negotiating “at arm’s length on the basis of legal advice” and whether they had “every opportunity to appreciate what they were agreeing“. This suggests that, going forwards, the courts will be more reluctant to find that clauses agreed between two commercial and legally represented parties are penalty clauses and therefore unenforceable.
Importantly for construction contracts in particular, the Supreme Court considered the notion that a clause was considered penal if it was meant as a deterrent to be “unhelpful” and that the focus on whether the stipulated sum was a genuine pre-estimate of loss was “an artificial concept if applied to clauses which have another commercial justification“. It thus seems that the ‘deterrence’ test is likely to be of less relevance (if any) when considering whether or not a provision is a penalty. It is not clear how much significance the courts will place on whether liquidated damages are a pre estimate of the loss likely to be suffered. The real question will be whether the clause is penal, not whether it is a pre-estimate of loss.
The extent of the doctrine
The Supreme Court confirmed the decision of the Court of Appeal that the penalty rule not only applies to contractual remedies stipulating a payment of money but equally to:
- obligations to transfer assets; and
- withholding of payments,
where one party is in breach of default.
However, for the type of LDs clause typically seen on a construction project, this extension will be of less relevance.
So, what are the key implications of the judgment?
This decision represents a significant redefinition of the law. The court has re-written the rule and introduced a more flexible test, which is intended to be applicable to more complicated cases.
In some cases, liquidated damages which may be designed to deter a party from breach, and which do not represent a genuine pre-estimate of loss, may now be enforced. The party wishing to rely on the clause would need to show that a legitimate business interest was served by the clause, and that it was not ‘extravagant, exorbitant or unconscionable’, or ‘out of all proportion to any legitimate interest of the innocent party’. In many cases, the result will be the same, but it is likely that there will be some clauses that would have been unenforceable under the old test, which will now be valid and enforceable.
It is plain the decision has re-opened the issue of penalty clauses and we can expect plenty more litigation on what was a previously settled area of the law.
The key issues which are bound to now be raised are:
- How the courts will approach the new tests laid out by the Supreme Court, as to what constitutes:
- the “legitimate business interests of an innocent party“; and
- a detriment that is “out of all proportion to any legitimate interest of the innocent party“; or “extravagant, exorbitant or unconscionable“.
- The significance placed on liquidated damages that are a genuine pre estimate of the loss. The fact the Supreme Court described Lord Dunedin’s tests as a ‘useful tool’ indicates LDs that do represent a genuine pre-estimate of loss will still be enforceable under the new test.
- Whether alleged penalty clauses are in fact primary obligations. Expect a new battleground to be formed around whether provisions within contracts are primary obligations and not secondary, thereby not engaging the doctrine of penalties.
- Whether clauses drafted to be primary obligations should still be viewed as a disguised penalty clause because its purpose is only to punish the party in breach and thus as a matter of public policy it should not be enforced.
There is also an issue as to the circumstances in which a withholding clause may fall within the doctrine. Notably, the Lords did not fully agree on this issue.
What does this mean for your construction project?
The two clauses debated in Makdessi involved the withholding of two lump sum payments to Mr Makdessi on his default and the forced sale of shares at an unfavourable price. These are not the typical LDs clauses seen in construction contracts where a contractor / subcontractor pays or allows a sum of money to the Employer / Contractor for every week beyond the contractual completion date. However, these sorts of clauses may have more applicability to the failure to achieve performance standards.
The ParkingEye case also involved the payment of one lump sum payment and so again is different to typical LDs on construction projects. However, the court’s views on why the charge was not penal, despite clearly being meant as a deterrent, will be encouraging to those seeking to rely on tough LD provisions.
This decision will create doubt for contract drafters regarding how to avoid LDs being viewed as penalty clauses. The following practical tips (some of which will be familiar from the old test and some of which may be new) should help to ensure that clauses are enforceable:
- Identify the applicable legitimate business interest: To the extent possible, identify the commercial purpose of the liquidated damages and set this out in an appendix or a side letter.
- A genuine pre-estimate of loss is still helpful: It is unlikely that liquidated damages provisions which do represent a genuine pre-estimate of the loss will be unenforceable under the new test.
- Don’t combine multiple events into a single LDs clause: Lord Dunedin’s tests still provide useful guidance, and as such, parties should avoid ‘catch all’ LDs which are triggered on events of differing seriousness and financial consequences. Try to separate out LDs for late completion and failure to meet performance standards, for example.
- Draft as a primary Obligation?: We envisage that parties may start to attempt to draft LDs clauses in such a way as to increase the likelihood that they will be viewed as primary obligations that do not engage the penalty doctrine. This may help in some circumstances, but care should be taken in relying too heavily on this, as Lords Sumption and Neuberger cautioned that courts will look at the true nature of the clause, rather than necessarily whether it has been expressed as a primary or secondary obligation.
- Equal bargaining power: Where it is the case, include a provision that the parties are of equal bargaining power and have been advised by solicitors, in order to address the considerations of Lord Mance. This may be of particular significance when dealing with smaller subcontractors, although again courts will look at the reality of the situation.
The Supreme Court decision should make it less likely that liquidated damages will be unenforceable. However, problems will no doubt arise as parties seek to push the boundaries of the new test, leaving it to the courts to provide guidance on when provisions are “out of all proportion to any legitimate interest“.