2016 Penalties 39 Knocked out on penalties Kate Corby, Partner, and William Jones, Associate, Baker & McKenzie Liquidated damages clauses and the rule against penalties WITH Euro 2016 in full swing at the time of writing, the rule against penalties may sound like a dream come true for any die hard England fan. Indeed, the Supreme Court’s handing down of its decision in the case of Cavendish Square Holding BV v Talal El Makdessi (2015) UKSC 67 on 4 November 2015 was awaited with almost as much anticipation as this year’s main event in the footballing calendar. El Makdessi was the first time in a century that the UK’s most senior court had considered the rule against penalties, and some commentators had speculated that the Supreme Court might use the opportunity to abolish this principle. The rule against penalties operates to prevent enforcement of a contractual clause that imposes a penalty on a party who has breached the contract. The logic is that a party should be free to breach a contract, provided it pays damages to its contractual counterparty, which should compensate the innocent party for the loss it suffers arising from the breach, rather than act so as to punish the defaulting party. The penalty rule most commonly comes into play in construction contracts in relation to the enforceability of liquidated damages provisions. Liquidated damages provisions are used to agree in advance the level of damages one party will pay to the other if it breaches the contract. Such clauses are attractive as they provide a contractor with certainty about the maximum liability it could face in relation to the relevant breaches, thereby offering a means of controlling the level of risk taken on in relation to a particular contract. In addition they, in theory at least, allow for disputes to be resolved quickly and without recourse to the courts (or an arbitral tribunal). In practice, however, the question of whether liquidated damages are unenforceable due to the penalty rule may itself lead to a time-consuming and bitterly contested satellite dispute. Ultimately, the Supreme Court did not use El Makdessi to kick the penalty rule out of English contract law. It did, however, reformulate the legal test as to whether a clause should be classed as an unenforceable penalty. In this article, we examine how El Makdessi has re-shaped the penalty rule in the context of liquidated damages clauses, and look forward to what impact this may have on businesses in the construction industry in the future. Previous law Prior to the judgment in El Makdessi, the leading case was Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd (1915) AC 79. The speech of Lord Dunedin in this case contains the guidance that was most commonly referred to by practitioners on the distinction between a penalty and a liquidated damages clause. This can be summarised as follows: 1. Although the words the parties use to describe a particular provision are not irrelevant, the court must decide in substance whether a provision is a penalty or a liquidated damages clause. 2. The essence of a penalty is that it seeks to deter a party from committing a breach by requiring them to pay money on occurrence of that breach. The essence of a liquidated damages clause is that it is a genuine pre-estimate of loss agreed by the parties. 3. Whether a provision is a penalty or liquidated damages clause depends on the terms and circumstances of each particular contract, assessed from the perspective of when the contract was created, rather than when the breach occurred. 4. A number of tests may be used, which if applicable to a particular case, may assist with assessing the nature of a particular provision: Some commentators had speculated that the Supreme Court might use the opportunity to abolish this principle. 40 Penalties Construction Law Review The El Makdessi decision The decision in El Makdessi has reformulated the law against penalties, and arguably allows more flexibility for contracting parties when it comes to devising liquidated damages, or similar, clauses. In the leading joint judgment, Lords Neuberger and Sumption explained as follows: “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.” 1 It is also useful to look at the language used to set out the legal test in the judgments of the other lords. Lord Mance explained the test as follows: “What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances, extravagant, exorbitant or unconscionable.” Lord Hodge’s formulation was: “…the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract.” On first reading, one may be forgiven for thinking that their Lordships’ language does more to cloud rather than clarify matters. Nonetheless, our view is that the El Makdessi judgment can be unpacked into a three-step test, as follows: • Step 1: Does the clause in question only come into play once a breach has occurred (i.e. is it a secondary, rather than a primary, obligation)? • Step 2: Does the innocent party have a legitimate business interest that the clause serves to protect? • Step 3: Are the consequences of the clause for the party in breach out of all proportion to the legitimate business interest of the innocent party? Aside from the re-formulation of the legal test for the penalty rule itself, El Makdessi 1 The distinction between primary and secondary obligations is that the former is a contractual obligation to be performed in the normal course of the contract, and the latter is one that only comes into play if the contract is breached a. A provision will be a penalty if the sum payable is ‘extravagant and unconscionable’ when compared with the greatest loss that conceivably could have followed from a breach. b. A provision will be a penalty if the breach in question is a party failing to pay a sum of money, and the sum payable is larger than the amount that ought to have been paid in the first place. c. There is a presumption that a clause will be a penalty if the same amount is required to be paid when one, or more, of several different breaches occur, and some of these events cause serious, and others insignificant, loss to the innocent party. d. Nevertheless, a provision should not be prevented from being enforced simply because the consequences of the breach were almost impossible to predict when the contract was entered into. Looking at this guidance more closely, points 1 and 3 can be said to be restatements of general principles of contractual interpretation. As such, point 2, taken in light of the four tests set out in point 4 (as applicable), was previously taken to be the classic test of whether a liquidated damages clause was enforceable or not. Simply put, under the old law, a liquidated damages clause would be enforceable if the amount to be paid on a particular breach of a contract represented a genuine attempt by the parties to estimate what the likely loss flowing from that breach would be. On the contrary, a clause would be an unenforceable penalty where its core intention was to deter the potential payer of damages from breaching the contract, or where the amount of damages to be paid was clearly disproportionate compared to the amount of loss that could have been envisaged to flow from the breach. Prior to the decision in El Makdessi, commentators and practitioners had expressed widespread frustration with this formulation of the law for numerous reasons. For example, the rule against penalties seemed to represent a flagrant contradiction of the principle that contracting parties should have the freedom to decide between themselves the terms of agreements that bind them, which is at the heart of English contract law. Further, there did not appear to be any good reason why including a term in a contract designed to deter one party from breaching the contract should be unenforceable. Indeed, the risk of being liable to pay damages itself functions as a deterrent against breach. Another frustration lay in the fact that the task of attempting to estimate in advance the likely loss flowing from a breach felt very much like arbitrary crystal-ball gazing. Finally, this formulation of the law prevented a number of contractual mechanisms put in place for sensible and practical commercial reasons. One example would be a consideration clause that offered bonus payments where a party delivered a project early by a set time period, tied with a clause that reduced the level of consideration by an equivalent amount if a project were delayed by that same amount of time. This carrot and stick approach to encourage a contracting party to complete work on time makes good commercial sense. Nonetheless, under the old law against penalties, unless the clause reducing the consideration could be said to represent a genuine pre-estimate of loss, it could fall to be unenforceable. Indeed, the risk of being liable to pay damages itself functions as a deterrent against breach. 2016 Penalties 41 provision dealing with the consequences of breach’ are honoured by the lower courts. For those in the process of drafting, or analysing the enforceability of, a liquidated damages clause, our guidance would be to refer first to the three-stage test set out above. If the clause can also be shown to pass the ‘genuine pre-estimate of loss’ test, this should provide additional comfort that it will be enforceable. This approach should allow players to enforce liquidated damages clauses in the course of a project, without wasting extra time debating whether or not something falls foul of the penalty rule. Kate Corby, Partner, and William Jones, Associate, Baker & McKenzie Kate.Corby@bakermckenzie.com William.Jones@bakermckenzie.com www.bakermckenzie.com @bakermckenzie Kate Corby is the ICES advisory solicitor. contains some other guidance as to how the rule against penalties operates and when it will come into play. Specifically, the court made clear that in a commercial context, the principle of freedom of contract should be upheld as far as possible: “In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.” Their Lordships also appeared to remove (or at least lessen) consideration of the concepts of ‘genuine pre-estimate of loss’ and whether a clause acts as a deterrent to breach, from the legal test. Distancing their analysis from that of Lord Dunedin in Dunlop, Lords Neuberger and Sumption explained: “The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a preestimate of loss… The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. To describe it as a deterrent… does not add anything. A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected.” Nonetheless, the court refrained from abandoning the concept of ‘genuine pre-estimate of loss’ altogether, and seemed to suggest that this test may still have some use in the liquidated damages context. Lords Neuberger and Sumption said that: “In the case of a straightforward damages clause, [the innocent party’s] 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.” Lord Hodge echoed this and went further still, stating that: “The focus on the disproportion between the specified sum and damage capable of pre-estimation makes sense in the context of a damages clause…” He continued: “Where the test [for a penalty] is to be applied to a clause fixing the level of damages to be paid on breach, an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach would amount to a penalty and thus be unenforceable.” This element of the Supreme Court judgment seems somewhat self-contradictory, and may ultimately lead to some confusion when considering the enforceability of a liquidated damages clause. Nonetheless, our view is that their Lordships were unequivocal that the genuine legal test for assessing whether a clause is penal is the three-step test we set out earlier. Comment At the time of writing, there have not yet been any reported cases that apply the El Makdessi decision to a liquidated damages scenario. As such, it remains to be seen how the courts will interpret the Supreme Court’s reframing of the penalty rule, and whether they will allow contracting parties more leeway to agree in advance the amounts of damages to be paid on breach. Since liquidated damages provisions are a useful and practical tool for parties to avoid disputes arising from construction projects, it is hoped that the Supreme Court’s comments about parties being themselves the ‘best judges of what is legitimate in a Does the clause in question only come into play once a breach has occurred? Not a penalty Does the innocent party have a legitimate business interest that the clause serves to protect? Penalty Are the consequences of the clause for the party in breach out of all proportion to the legitimate business interest of the innocent party? Not a penalty Penalty N Y Y N N Y The penalty flowchart.