On 4 November 2015, the Supreme Court handed down judgment in joint appeals relating to Cavendish Square Holdings Ltd v Talal El Makdessi (the "Cavendish Appeal") and ParkingEye Ltd v Beavis (the "Beavis Appeal")1. These appeals provided the first opportunity for the Supreme Court, or the House of Lords, to consider the law concerning penalty clauses in approximately 100 years.
The two appeals related to non-construction-related disputes. The Cavendish Appeal concerned the effect of two clauses related to non-compete covenants in an agreement regarding the sale of a controlling stake in business. The Beavis Appeal concerned the enforceability of a parking fine.
As Andrew Weston sets out below, the Supreme Court judgment is relevant to construction contracts as it impacts upon the law relating to liquidated damages.
The most important proposition of law impacting on liquidated damages provisions typically found in construction contracts is derived from the leading judgment of Lord Dunedin in Dunlop Pneumatic Tyre Company Ltd v New Garage Motor Co Ltd (1915).2
Following Dunlop the test commonly applied was: are the liquidated damages a genuine pre-estimate of the loss (rendering the clause compensatory)? If so, the clause was unlikely to be regarded as a penalty. However, if the amount of liquidated damages bore absolutely no resemblance to the loss, was extravagant and unconscionable, and was intended to deter a breach of contract, the court would be more willing to construe it as an unenforceable penalty.
As a consequence, an employer did not need to prove that it had actually suffered the loss covered by the liquidated damages provision. The liquidated damages could be recovered even if its actual loss was lower, providing they represented a genuine pre-estimate of the loss. If not, the provision was open to challenge on the basis it was a penalty clause, and not recoverable as a matter of law.
The Cavendish Appeal
Mr Makdessi agreed to sell a controlling stake in the largest advertising group in the Middle East to Cavendish. The terms of a share sale agreement ("the Agreement") contained restrictive covenants requiring Mr Makdessi not to become involved in a competing business. The sanctions for default were that Mr Makdessi would:
(i) forfeit the balance of price payable by Cavendish for his shares; and
(ii) be required to transfer all his remaining shares to Cavendish at a price which excluded any goodwill value.
Mr Makdessi accepted he had breached the restrictive covenants, but he denied the clauses were enforceable on the basis they were penalties.
At first instance, Mr Justice Burton found that the purpose of the restrictive covenants was not to deter a breach of contract, but to adjust the consideration between the parties. Cavendish was entitled to assess the value of a breach of the restrictive covenants by reference to the greatest loss that could conceivably be proved to have followed from the breach, given the potential for a substantial impact on the goodwill of Cavendish's business. Accordingly, the clauses were not found to be penalty clauses. Mr Makdessi appealed.
The Court of Appeal reviewed the law on penalties. It noted that the purpose of a penalty clause was to deter breaches of contract, and a clause would only be a penalty if it was "extravagant" and "unconscionable". Reference was also made to the more flexible approach taken in cases since Dunlop and focused on the dominant purpose of such clauses. It concluded that if the dominant purpose of a clause was to deter a breach of contract, and the amount of the sanction was commercially justified, then it was not a penalty clause.
The Court of Appeal upheld the appeal, finding that the two clauses were unenforceable penalty clauses intended to deter a breach of contract. It was found the provisions did not reflect a genuine pre-estimate of loss, were extravagant and unreasonable compared with the likely damage arising from the breach, and had no commercial justification. As a result, they were unconscionable. Cavendish appealed to the Supreme Court.
The Beavis Appeal
Mr Beavis parked his car at the Riverside Retail Park car park, Chelmsford, a car park operated by ParkingEye. Prominent signs were displayed around the car park advising that the maximum stay was two hours, after which time a parking charge of £85 would apply. Mr Beavis overstayed the maximum stay by one hour, as a result of which he was charged £85. He refused to pay on the basis that the clause was a penalty and was therefore unenforceable.
At first instance HHJ Moloney QC found in favour of ParkingEye. The Judge held that a motorist who parked in the car park did so on the terms and conditions at the entrance and on the noticeboards, which represented the contract between ParkingEye and Mr Beavis. The contract included an obligation to leave within two hours, in default of which there was an agreement to pay the £85 charge. The Judge acknowledged that the charge had the characteristics of a penalty as ParkingEye did not suffer any identifiable financial loss as a result of Mr Beavis' breach.
The Judge found that the predominant purpose of the £85 charge was to deter motorists from breaching the maximum two-hour free stay period (and therefore the contract), which would at first glance render it a penalty. However, the Judge found that the charge was commercially justifiable, was not improper or excessive in amount in the circumstances, and was not unfair pursuant to the Unfair Terms in Consumer Contract Regulations 1999 ("UTCCR"). Accordingly, the charge was enforced. Mr Beavis appealed.
The Court of Appeal considered:
(i) whether the £85 charge was unenforceable at common law on the basis it was a penalty; and
(ii) whether the charge was unfair (and therefore unenforceable) under the UTCCR.
In relation to the penalty issue and deciding whether the charge was extravagant and unconscionable under Dunlop, the Court of Appeal followed Judge Moloney QC's approach of considering the charge having regard to the actual loss suffered, the deterrent effect of the clause, and whether it was justifiable commercially.
The court held that the charge was not a genuine pre-estimate of loss; it was aimed at deterring motorists from overstaying the permitted period; was not extravagant or unconscionable; and crucially, was justifiable for both commercial and social reasons. The £85 charge was therefore upheld. Mr Beavis appealed to the Supreme Court.
Decision of the Supreme Court
The Supreme Court considered the development of the law in relation to penalty clauses. It noted that the distinction between a clause providing for a genuine pre-estimate of damages and a penalty clause had remained fundamental to the modern law as it was understood.
Two questions were posed:
(i) in what circumstances is the penalty rule engaged at all: and
(ii) what makes a contractual provision penal?
In relation to the circumstances in which the rule is engaged, it is necessary to consider how the obligation is framed, i.e., whether it is a conditional primary obligation or a secondary obligation providing an alternative to damages. This is fundamental as "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".
Conversely, "if the contract does not impose... 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."
In relation to the question as to what makes a contractual provision penal, reference was made to the four tests formulated by Lord Dunedin in Dunlop and to the essential question as to whether the agreement was "unconscionable" or "extravagant".
It was acknowledged that Lord Dunedin's four tests were useful tools for deciding whether a provision was unconscionable or extravagant where there were simple damages clauses in standard contracts. They were not easily applied to more complex cases. Lord Neuberger and Lord Sumption also noted that the assumption that a provision cannot have a deterrent purpose if there is commercial justification seemed to be questionable.
The Supreme Court was unanimous that the doctrine of penalties should not be abolished. However, the traditional test set down in Dunlop that a clause will be a penalty if it is not a genuine pre-estimate of loss and is found to be extravagant or unconscionable, or if its purpose is to deter a breach of contract, was rejected. The majority held that the correct approach in commercial cases was to have regard to the nature and extent of the innocent party's interest in the performance of the obligation that was breached as a matter of construction of the contract.
The test, formulated by the majority and set out at paragraph 32 of the Judgment, 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."
They went on to note:
"The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin's four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations."
Application of the test – the Cavendish Appeal
Applying this test to the facts in the Cavendish Appeal, the Supreme Court unanimously held that the two clauses in question were not penal in nature. The majority held that the clauses were primary obligations under the contract, as they provided for an adjustment to the purchase price that was equivalent to other primary price calculation clauses in the contract which meant the penalty rule was not engaged. This was distinct from secondary obligations that only come into play once a breach of contract occurs (such as an obligation to pay liquidated damages if the works are delayed). Further, the clauses were justified commercially by Cavendish's legitimate interest in protecting the goodwill of the business, and the parties were the best Judges of how that interest should be reflected in the contract.
Application of the test – the Beavis Appeal
In the Beavis Appeal the Supreme Court held that whilst the £85 charge was a secondary obligation, intended to deter motorists from a breach of contract (i.e. overstaying), it was not a penalty. This was so because ParkingEye, and also the car park owner, had a legitimate commercial interest in deterring motorists from overstaying by imposing a charge on them. The interest of the car park owner was the provision and efficient management of customer parking for the retail outlets.
The interest of ParkingEye was income from the £85 charge which met the running costs of what was considered by the Supreme Court to be a legitimate commercial scheme, plus a profit margin. The reasoning behind the imposition of the charge was entirely reasonable, and proportional to the commercial interests of ParkingEye and the car park owners. Accordingly, it was not penal.
Why is this case important to the construction industry?
A number of points arise out of the judgment:
- Liquidated damages are secondary obligations and are in principle caught by the new rule for penalties.
- As a general rule, there will be a strong presumption that the clause is not out of all proportion with the innocent party's legitimate interests if a commercial contract has been negotiated between two parties of comparable bargaining strength, and survived advisors' scrutiny. This is the case even if it is penal in nature, is intended to deter a breach of contract, and is not representative of any actual financial loss the innocent party would suffer.
- Losses that cannot be easily quantified, such as reputational issues, goodwill and third party interests (i.e. other commercial "interests") may fall to be considered in determining the level of liquidated damages.
- It is important to challenge liquidated damages that appear not to be commensurate with the commercial impact of delayed completion before the contract is executed.
The decision of the Supreme Court in the Cavendish and Beavis Appeals has replaced the century-old test in Dunlop with a more modern and flexible test. The test reflects the fact that parties may have a legitimate commercial interest to protect in enforcing the performance of contractual obligations which may extend beyond compensation for any identifiable commercial losses that breach may cause, or the deterrence of a breach of contract.
In the context of construction projects this new test will require consideration of the commercial justification for the liquidated damages clause at the time the contract was entered into; and whether the amount of liquidated damages is out of all proportion to the employer's legitimate commercial interest in deterring late completion of the works.
1.  UKSC 67
2. AC 79 ("Dunlop")
This article is taken from Fenwick Elliott's 2016/2017 Annual Review. To read further articles go to http://www.fenwickelliott.com/research-insight/annual-review/2016
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.