The claimant, AB, sought summary judgment for payment of liquidated damages (LDs) by the defendant, H, on lawful termination of the contract by AB. The LDs were stated to amount to 20% of the contract price. H, perhaps inevitably, claimed that the LDs clause was unenforceable because it was a penalty.
H said that the only way for the court to determine whether the LDs clause was a penalty or not was for it to hear evidence at a full trial as to the maximum possible loss that the parties would have expected to flow from termination. The contract concerned the building of a yacht, so that would include evidence as to the yacht market, whether the yacht could be sold elsewhere, how long that would take, the costs involved (including financing costs) and so on.
The judge gave short shrift to those contentions. He said that the clause in question was not even arguably a penalty because:
- On the evidence it was clear that the purpose of the clause was not to deter breach of contract, and that it was commercially justifiable as providing a balance between the parties.
- Both parties had the benefit of expert advice.
- The terms were freely entered into.
- In a commercial contract, what the parties have agreed should normally be upheld.
A new test?
In summary, the judge said that a clause will not be a penalty as long as it is commercially justifiable, and it will be commercially justifiable if it provides a balance between the parties on the occurrence of the event in question. A clause will therefore only be unenforceable as a penalty if it is “extravagant and exorbitant”.
Liquidated damages v penalties
It is well known that a clause will be unenforceable as a penalty if its purpose is to deter breach. However, an LDs clause, the purpose of which is to pre-quantify the level of damages that the parties consider will be suffered or incurred by the innocent party on the occurrence of a particular breach, is permissible.
Does this distinction accord with commercial reality? Ask any employer why it includes an LDs clause for delay, and usually the answer will be to make sure that the contractor finishes on time. Ask the contractor, and he will tell you (depending on the deal he has done) that he had to agree to it to get the job, or that at least his potential liability for delay is capped by the LDs clause.
Given that an LDs clause is likely to be enforceable so long as it is not extravagant or exorbitant, where is the dividing line really to be drawn between a penal deterrent and a permissible LDs clause?
The Scottish Law Commission has recently published its Penalty Clauses Bill, suggesting that a clause should be unenforceable if the amount to be paid under it is “manifestly excessive”. It appears that, to all intents and purposes, this is the test which the English courts are applying.
However, is this a new test or just another way of dealing with something that has long been an anomaly in English contract law? Even in the Dunlop Pneumatic Tyre case itself, one of the Law Lords commented that “[i]t is too late to question whether such interference with the language of a contract can be justified on any rational principle.”
There are many examples of the courts being reluctant to interfere with the rights of commercial parties to contract freely. The courts would not help a contractor if it entered into a bad bargain or if it entered into a contract for a very low sum with a large bonus for finishing early (subject to any UCTA considerations).
Similarly, it is only in rare cases that a court will find that an LDs clause (or a clause of a similar type) in a commercial contract is unenforceable as a penalty. In those cases it is usually because of mistakes in bespoke drafting. Examples are where operation of the LDs clause is not clear in relation to sectional completion or partial possession, or where a party has been made liable for LDs for an event that was caused by a third party.
Do all roads lead to the same end?
The commercially justifiable test has been applied in several cases recently where the LDs clause was clearly not a pre-estimate of the innocent party’s loss but was not so exorbitant as to amount to a penalty. Jackson LJ’s judgment in Alfred McAlpine v Tilebox referred to the “reasonableness” of the damages stipulated in the contract and whether they were “extravagant” when compared with the amount of damages likely to be suffered.
Generally speaking, unless an LDs clause is extravagant or exorbitant and clearly intended to deter one party from breaching the contract, it is unlikely to be struck out as a penalty and the various authorities do all appear to lead to this end. So perhaps the saying is true: it’s not so much which road you take, as how you take it.
This blog was first published by PLC Construction as part of our regular construction blog series in which we share our practical experiences of working in construction and engineering and give our opinion on the current and future legal developments that shape and will shape the industry. Please select the link for other PLC Construction blogs.