Between a rock and a hard place: is the law on liquidated damages unfair to employers?

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Summary: Two new cases on penalties have revived two old concerns. Do the courts interfere too much with the validity and operation of liquidated damages clauses? And if they do, is it always the employer that suffers? The new cases are not construction cases, but they could be of concern for employers seeking to rely on their liquidated damages (LD) clauses.

Two new cases on penalties have revived two old concerns. Do the courts interfere too much with the validity and operation of liquidated damages clauses? And if they do, is it always the employer that suffers?

The new cases are not construction cases, but they could be of concern for employers seeking to rely on their liquidated damages (LD) clauses. One is the parking fine case, Parkingeye v Beavis. In this case the Court of Appeal held that a parking fine (which was a term of the contract between the car park management company and the motorist) was not a penalty even though it was obviously intended to deter a breach. This was because it was justifiable, perhaps not on commercial grounds, but considerations of social and public interest. In so deciding, the court drew a clear distinction between that case and “commercial” cases, and left the law in a state of uncertainty around the concept of deterrence, which may not be resolved until the case goes before the Supreme Court.

The other is an international shipping case, MSC Mediterranean Shipping Company SA v Cottonex Anstalt. In this case, the contract provided that the carrier could charge demurrage on containers not returned to it and this liability was uncapped. The carrier still had not received its containers three years later, but the court held that it was not entitled to keep on charging demurrage throughout this period. In the court’s view, the law should encourage efficiency and the productive use of resources. As a result the carrier had to forget about its contractually agreed remedy, accept the shipper’s repudiation and go and buy replacement containers. This was not in mitigation of damages – because that principle does not apply to LDs clauses – but in order to prevent the shipper’s liability growing to enormous levels and the clause being held to be penal.

Where does this leave the concept of deterrence?

Employers may be justified in feeling rather left out by these decisions. In Parkingeye the court stoutly defends the public interest in having a regular turnover of parking spaces; in MSC v Cottonex it bravely pursues the socio-economic goal of the efficient use of resources. Yet one objective that remains suspect, and in many cases fatal to the survival of a clause, is that of deterring breaches of contract, or securing performance, in a commercial context.

Quite apart from that, the two decisions may add fuel to the fiery debate about whether a contractor’s liability for LDs survives termination of its contract.

Do LDs survive termination?

You may remember Hall v Van der Heiden, in which Coulson J decided that the employer could continue to claim LDs after termination. Despite that decision, many commentators still think the basic position is that LDs are not payable after termination, and the employer can only recover its cost to complete and other losses arising from the termination. One matter relied on to explain away Hall is the fact that it concerned a residential project rather than a commercial one. That rationale could be reinforced by the distinction drawn in Parkingeye between the public interest sort of case and commercial cases. But why, pleads the employer, should it make a difference? Why should my LDs have a limited shelf life when the houseowner’s did not?

When the question of LDs surviving termination comes before the courts again, surely the contractor will rely on MSC v Cottonex and argue that, just like the carrier without its containers, the employer without its building cannot simply continue to charge weekly damages until practical completion. No, it has to ignore that provision and rely on other contractual remedies. That is, if it has any. Following the logic of MSC v Cottonex further, the employer should, in such circumstances, take active steps to prevent the liquidated damages escalating to such a level that they will become penal. That is not a duty to mitigate, but looks rather like it.

Is the law on penalties unfair to employers?

So is it all dreadfully unfair? In one respect, perhaps. If the principle in MSC v Cottonex is applied in a construction context to oblige the employer to take steps to limit the LDs, the employer would run up against the principle that LDs are generally an exhaustive remedy and that employers cannot recover any costs incurred in mitigation (see Biffa Waste Services Ltd and another v Maschinenfabrik Ernst Hese GMBH and others). In practice, most construction contracts contain a cap on LDs so perhaps this issue simply will not arise very often.

Aside from that, however, the position is still well balanced. The law on penalties is much more flexible than it used to be, and there is a regular flow of cases upholding LDs clauses on the basis of commercial justification. And even where an LDs clause falls over, or if it expires on termination, the employer may – if it drafted its contract carefully – have its remedy in general damages. So while recent cases seem to pursue diverse objectives and maintain the law’s suspicion of an employer’s goals in deterring breaches of contract and enforcing its contractual rights, in practice employers are not being disadvantaged by the evolving law on penalties.

This article was first published by Practical Law 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. To read more from the series, visit the Practical Law blog.

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