We recently reported on the Supreme Court’s decision in the Cavendish and ParkingEye appeals. The court’s decision has significantly changed the law with regard to contractual penalties. In this Law-Now we take a closer look at the effect of the decision on construction contracts.

The Supreme Court’s decision

For a detailed summary of the Supreme Court’s decision and its impact on the law of penalties, please see our earlier Law-Now here.  In very brief terms, the Supreme Court has ruled that:

  • The true test for whether a clause is a penalty is “whether the impugned provision is a secondary obligation [i.e. a clause providing an alternative to damages at common law for breach of contract, typically the payment of a liquidated sum] 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.”
  • In straightforward cases, where a party’s interest in performance of a contractual obligation will be met by financial compensation, the existing rules focusing on whether a clause is a “genuine pre-estimate of loss” or is intended primarily as a deterrent are likely to be sufficient. In more complex cases, where there are other factors in addition to financial losses, a broader enquiry focusing on the legitimate interest of the innocent party will be appropriate.

Implications for construction contracts

Construction contracts will often contain liquidated damages clauses for example for delayed completion. For projects which have purely commercial ends, the Supreme Court’s decision may not result in any meaningful change in current practices. Contracts for the construction of office blocks or process plants, for example, are likely to be cases where the employer’s interest in timely completion will be met by financial compensation. Whether a liquidated damages clause in such circumstances is liable to be struck down as a penalty is still likely to depend on an enquiry into the commercial losses likely to be suffered by the employer in the event of delay.  There are, however, a large range of circumstances in which an employer’s interest in performance would not be met fully by financial compensation and where the new test expounded by the Supreme Court is likely to provide much greater scope for the drafting of liquidated damages provisions. For example:

  1. Certain projects carry reputational risks as well as financial risks. Construction contracts for the Olympic Games or other regular sporting fixtures, for example, involve large reputational risks to the employer in the event that work is not completed on time. The employer’s interest in timely completion is unlikely, therefore, to be met fully by compensation for financial losses alone.
  2. In a similar vein, public infrastructure projects often carry large political and social risks in the event of delayed completion or a failure to meet performance requirements. For example, a government authority may not suffer financial losses in the event of the delayed completion of a highway, but still has a substantial interest in ensuring that construction is completed on time. Even if financial losses are suffered, they are unlikely to represent the full extent of the authority’s interest in the project.
  3. Liquidated damages are sometimes sought to be imposed by employers for publicly sensitive issues such as health and safety or environmental damage. An employer’s interest in such matters will often involve moral and reputational elements and again is unlikely to be met fully purely by reference to financial compensation.

The Supreme Court has also provided guidance as to scope of the penalties rule and so called “disguised penalties”. The court confirmed that the penalties rule is limited to secondary clauses which operate upon a breach of a primary obligation and in doing so refused to follow developments in Australia which had extended the rule to circumstances where no breach of contract arise. 

Having said that, the dividing line between what constitutes a “primary obligation” and what constitutes a “secondary obligation” will not always be obvious. The court provided some guidance on the point – for example, a useful rule of thumb seems to be whether there is a “fall back” position at common law if the clause was to be struck down as a penalty (such as a right to claim general damages); if there is, the clause in question is likely to be a “secondary obligation” (see paragraph 83 of the judgment). However, the court accepted that “the application of the penalty rule can still turn on questions of drafting”. Nonetheless, courts are still able to apply the penalty rule where a “realistic appraisal of the substance of contractual provisions” shows that they are intended to be secondary obligations dependent on the performance of primary obligations, even where drafted in terms which avoid any breach of contract arising. 

In a construction context, such a debate may arise in relation to bonuses for early completion. The mirror image of contractual provisions for the payment of liquidated damages for delay are provisions which provide bonuses for early completion. It is possible to use the latter in place of (rather than as well as) the former - the originally intended contract price can be decreased by the maximum liquidated damages payable and the date for completion pushed back to match the period of delay applicable to those liquidated damages. Bonuses are then payable on a daily/weekly basis for the period between the originally intended date for completion and the deferred contractual completion date. By this means the originally intended contract price will be payable if the originally intended date for completion is met, with the contract price decreasing for delays beyond this date. 

The extent to which such attempts to draft around the penalties rule will succeed is difficult to judge in advance and will depend on all of the circumstances surrounding the contract. The Supreme Court has indicated that drafting out of the rule will be permitted in some circumstances, but not where the court is able to see through to the substance of the arrangement as in truth being one for the payment of liquidated damages. 

The Supreme Court’s decision is likely to take time to work through in practice and further decisions in the future are likely to be needed to test its boundaries. For the time being, the decision appears to provide greater scope to deal with non-financial risks through the use of liquidated damages provisions and preserves the ability, save in contrived circumstances, to structure agreements to avoid the penalties rule. 

References:

Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67