UK: Liquidated Damages And The Law On Penalties

Last Updated: 19 November 2015
Article by Rachel Chaplin

Liquidated damages, or "LDs" clauses have long been a feature of construction contracts. They provide for a pre-determined sum to be paid by way of compensation in the event of a breach of a stipulated contract term.

Most typically, they provide that, where a contractor fails to complete the contract works by the stipulated date, then it shall pay the employer, or allow the employer to deduct, LDs at the given rate per day or week for the period during which the contract works remain incomplete.  As such, the primary obligation, to complete the works on time, is replaced by a secondary obligation, to pay the LDs.  Such provisions may also be used where certain performance criteria are to be achieved. The advantage of this arrangement is that the contractor has certainty as to the financial exposure it faces for breach of contract, whilst the employer does not have to incur time and expense proving its loss.

LDs have been recognised as commercially desirable by the courts, always providing that they do not fall foul of the law on penalties, which provides that the LDs must represent a "genuine covenanted pre-estimate of damage". This principle was established a century ago, in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co  which suggested that an LDs provision would be unenforceable  if the amount payable was "extravagant, exorbitant or unconscionable."  This has led to a number of challenges to LDs clauses on the basis that they constituted a penalty.

More recently, the lower courts have refined their position in relation to the operation of LDs clauses, with an acknowledgement that in certain circumstances there may be a "commercial justification" for such provisions even where the amount to be paid appears penal. Now, for the first time in a century, the Supreme Court has considered the "penalty rule".

Commenting that the rule is "an ancient, haphazardly constructed edifice which has not weathered well", on 4 November 2015 the Supreme Court handed down its judgment in relation to two conjoined appeals that turned on the penalty rule, which are summarised below.

Background to the Supreme Court appeals

In Cavendish Square Holding BV v Talal El Makdessi, Mr Makdessi had entered into an agreement to sell Cavendish a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. Two clauses of the agreement provided that if he breached certain restrictive covenants Mr Makdessi (a) would not be entitled to receive the final two instalments of the sale price (clause 5.1); and (b) may be obliged to sell his remaining shares to Cavendish, at a price that excluded the value of the goodwill of the business (clause 5.6), thus ostensibly well below value. When Mr Makdessi breached those covenants, he argued that the two clauses were penalty clauses, which were unenforceable. At first instance, the Court found against Mr Makdessi, holding that the clauses were not penalties, and were enforceable. Mr Makdessi then appealed, and the Court of Appeal overturned the first instance decision, holding that the clauses were unenforceable penalties.  This decision was then appealed to the Supreme Court by Cavendish.

In ParkingEye Ltd v Beavis, ParkingEye Ltd and the owners of the Riverside Retail Park in Chelmsford agreed to manage a car park together. ParkingEye put up several notices around the car park stating that any failure to comply with a two hour parking time limit would "result in a Parking Charge of GBP 85". When Mr Beavis overstayed that two hour limit by almost an hour, he argued that the GBP 85 charge was a penalty at common law, and therefore unenforceable, and/or that the charge was unfair and unenforceable by virtue of the Unfair Terms in Consumer Contracts Regulations 1999 (SI 1999/2083) ("the 1999 Regulations"). At first instance, the Court disagreed with Mr Beavis and held that the charge was enforceable. The Court of Appeal upheld that first instance decision. Mr Beavis appealed to the Supreme Court.

Lord Neuberger and Lord Sumption gave a joint leading Supreme Court judgment on these appeals.  In both cases the clauses were found to be enforceable, with the outcome attributable to the facts of each case. The Supreme Court declined to overturn the penalty rule as a matter of principle. Lord Clarke, Lord Carnwath, Lord Mance and Lord Hodge all agreed. Whilst Lord Toulson agreed that the appeal in Cavendish v El Makdessi should be allowed, he dissented in ParkingEye v Beavis, but on the grounds that there had been a breach of the 1999 Regulations, not on the basis of any difference of view as to the law on penalties.

What makes a contractual provision a penalty?

The Makdessi / ParkingEye judgment has brought a modest refinement to the understanding of penalties, as set out in the Dunlop case referred to above. The Supreme Court considered the key precedent cases such as Dunlop but, after discussion, concluded that these are 'considerations'  which may not apply to every case, and that asking whether the clause is a genuine pre-estimate of loss or a deterrent may be helpful for straightforward LDs clauses, but not necessarily for more complex provisions where a broader test is required.

Instead, the real test to determine whether the clause is a penalty is whether the provision goes beyond the relevant party's "legitimate interest". The Court stated that, "the question of whether it is enforceable should depend on whether the means by which the contracting party's conduct is to be influenced are "unconscionable" or (which will usually amount to the same thing) "extravagant" by reference to some norm". The Court went on to state that "the true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter".

The Court also emphasised that the rule against penalties is concerned only with the secondary obligation to pay damages as the remedy for breach of an underlying primary obligation, and is not concerned with the primary obligation itself:

"There is a fundamental difference between a jurisdiction to review the fairness of a contractual obligation and a jurisdiction to regulate the remedy for its breach...the courts do not review the fairness of men's bargains...This means that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the instrument.... Thus, where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty."

This doesn't mean, however, that contracting parties can try to avoid the rule against penalties simply by labelling as a primary obligation what is, in reality, a contractual remedy for breach of a primary obligation.  To emphasise this, the Court added:

  "...the capricious consequences of this state of affairs are mitigated by the fact that...the classification of terms for the purpose of the penalty rule depends on the substance of the term and not on its form or on the label which the parties have chosen to attach to it."

Application of the test to the instant cases

In Cavendish Square Holding BV v Talal El Makdessi, the Court held that both clauses 5.1 and 5.6 were primary obligations.

The Court held that clause 5.1 was a price adjustment clause, not a contractual alternative to damages at law: "Although the occasion for its operation is a breach of contract, it is in no sense a secondary provision...Its effect is that the Sellers earn the consideration for their shares not only by transferring them to Cavendish, but by observing the restrictive covenants."  These covenants were intended to safeguard and protect the goodwill in the business, and the fact that the parties had agreed a price for their observance that bore no relation to the actual loss that would be recoverable on their breach was not a matter on which the courts could intervene:

"The goodwill of this business was critical to its value to Cavendish, and the loyalty of Mr Makdessi and Mr Ghossoub was critical to the goodwill. The fact that some breaches of the restrictive covenants would cause very little in the way of recoverable loss to Cavendish is therefore beside the point...It is clear that this business was worth considerably less to Cavendish if that risk [of breach of covenant] existed than if it did not. How much less? There are no juridical standards by which to answer that question satisfactorily. We cannot know what Cavendish would have paid without the assurance of the Sellers' loyalty, even assuming that they would have bought the business at all."

A similar analysis applied to clause 5.6, which was a primary obligation to sell the shares at a lower price.  Whilst the clause excluded goodwill from the calculation of the payment price in the event of a breach of the restrictive covenants and, therefore, did not represent the estimated loss attributable to that breach, it did reflect the reduced purchase price which Cavendish would have been prepared to pay on the basis that they could not count on the loyalty of Mr Makdessi.

In ParkingEye Ltd v Beavis, the Supreme Court held that Mr Beavis had a contractual licence to park in the car park on the terms of the notices put up around the car park, including the two hour limit. The GBP 85 was a charge for breaching the terms of that contractual licence. This is a common scheme, subject to indirect regulation by statute and the British Parking Association's Code of Practice. The Court held that, whilst the penalty rule was engaged in this case, the GBP 85 charge was not a penalty. The charge protected two legitimate business interests: (a) the efficient use of the car park, which benefited the Retail Park's shops and customers by deterring long-stay or commuter traffic; and (b) the generation of income in order to run the scheme, which benefited ParkingEye. These interests extended beyond the recovery of any loss; and the charge was no higher than was necessary to fulfil those interests.

What implications do these decisions have?

The penalty rule is long established, and has perhaps diminished in importance in light of statutory regulation, such as the 1999 Regulations. However, in these two cases, the Supreme Court observed that the rule is also common to many developed systems of law, and covers contracts not regulated by statute, such as non-consumer contracts. The rule is also consistent with other, well established principles developed by judges that involve the Court declining to give full force to contractual provisions, such as relief from forfeiture, equity of redemption and refusal to grant specific performance.

The Court was of the view that the parties themselves are the best judge of what constitutes a legitimate consequence of a breach, and extending the penalty rule could hinder freedom of contract. If the rule extended to other types of penalty, such as the ability to terminate a contract upon the occurrence of an insolvency event, that could represent an expansion of the Courts' jurisdiction into new, uncertain territories. On that basis, the Court felt the penalty rule should neither be abolished nor extended. This followed Lord Hoffmann's judgment in the case of Else (1982) Ltd v Parkland Holdings Ltd - [1994] 1 BCLC 130, where he stated "I would answer that the penalty doctrine, being an inroad upon freedom of contract which is inflexible compared with the equitable rules of relief against forfeiture, ought not to be extended."

If the contractual remedy is enforceable, its inclusion benefits contractually wronged parties in the event of breach. However, if a contractual clause does not relate to any legitimate business interest, and the remedy for any breach of it would be disproportionate considering the innocent party's interest in the performance of the contract, then the remedy is likely to be unenforceable.

As accepted by the Court in this judgment, the application of the penalty rule can still turn on questions of drafting. As noted above, LDs clauses are generally upheld by the courts, providing they do not constitute a penalty; it is therefore worth remembering when inserting such provisions that the obligation to pay LDs must be expressed as a secondary obligation which only operates once the primary obligation has been breached, and it should not be out of all proportion to any legitimate interest the injured party had in performance of the primary obligation.  Most standard form construction contracts contain straightforward LDs provisions, but care should be taken when amending these provisions or producing bespoke versions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.