When we think about a breach of contract and a remedy for that breach of contract, as often as not, we are thinking about damages - a monetary sum paid by the contract breaker to the innocent party that puts them in the position that they would have been but for the breach of contract.
To make a successful claim for damages, the innocent party needs to prove (i) the breach (of contract), (ii) causation (that the breach caused loss) and (iii) quantum (the amount of the loss). In practice, proving a claim can be both difficult and costly. Liquidated damages helps to overcome some of these challenges.
Liquidated damages are a predetermined agreed level of damages payable for a specified breach of contract. In effect, an agreement the purpose of which is to remove the possibly difficult and costly need to prove the loss.
Within the construction and engineering sector in particular, the use of liquidated damages as an Employer’s remedy for a Contractor’s delay in completing the works is well established and frequently provided for in both standard form contract conditions and bespoke contracts.
What is equally well known is the Contractor’s common defence to a claim for liquidated damages: the suggestion that the amount of the liquidated damages is a penalty and consequently unenforceable. It is this issue we focus on in this article.
It has long been an established English common law rule that a penalty is not enforceable. Determining whether the predetermined agreed liquidated damages are or are not a penalty is sometimes more difficult.
The test is set out in Lord Diplock’s speech in Scandinavian Trading –v- Flota Ecuatoriana  2 A.C. 694 at 702. Here it was held that liquidated damages that do not “…represent a genuine pre-estimate of any loss likely to be sustained as a result of the breach…” are likely to be a penalty and so begs the question: what is a genuine pre-estimate of loss?
Guidance comes from the speech of Lord Dunedin in the seminal House of Lords decision of Dunlop Limited –v- New Garage Co Limited  A.C. 79.
The simplified facts of the case are as follows. Dunlop sold tyres. In so doing it imposed a term on its customers that if they sold on the tyres, they were to do so at an agreed minimum price (£4 1s) and in breach, pay Dunlop liquidated damages of £5 per tyre sold. New Garage sold on tyres at £3 12s 11d; less than the agreed minimum price and less than the liquidated damages. Dunlop claimed liquidated damages and New Garage defended on the grounds that the amount claimed was a penalty.
Lord Dunedin identified 4 principles to help determine whether a sum was a penalty or a genuine pre-estimate of loss. Summarised they are:
- Terminology is largely irrelevant. It is for the court to determine as a matter of fact whether the agreed amount is a penalty or a genuine pre-estimate of loss1.
- The essence of a penalty is a payment which deters breach rather than compensates for the loss caused by the breach2.
- The agreed sum should be considered in context and at the time that the agreement was made3.
- There are a number of tests which may be helpful or indeed conclusive:
- The agreed sum will be a penalty if it is extravagant or unconscionable in the context of the greatest possible loss arising from the breach;
- If the breach is a failure to pay a sum of money (the principle sum) and the agreed sum payable by way of liquidated damages is greater than that principal sum, the agreed sum payable by way of liquidated damages will be a penalty; and
- There is a presumption that the payment of a single lump sum is a penalty.
THE NEW APPROACH OF COMMERCIAL JUSTIFICATION
There is a chain of cases which challenges the generally accepted orthodoxy that liquidated damages must be a genuine pre-estimate of loss and asks why parties to a contract, particularly commercial contracts, independently advised, cannot agree liquidated damages which are in excess of a genuine pre-estimate of loss and in fact represent a commercially justifiable amount.
In Lordsvale Finance plc –v- Bank of Zambia  3 W.L.R 668 the parties entered into various loan agreements in which Lordsvale loaned the Bank $230m. It was a term of the agreements that in default by the Bank, it would pay Lordsvale “default interest”. The rate of default interest was determinable by reference to a formulae and an additional unexplained 1%.
The Bank defaulted and in the subsequent proceedings argued that the default interest, particularly the additional unexplained 1%, was intended to deter breach rather than compensate for loss and was consequently a penalty and unenforceable.
The court held: “There would therefore seem to be no reason in principle why a contractual provision the effect of which was to increase the consideration payable under an executory contract upon the happening of a default should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, provided always that its dominant purpose was not to deter the other party from breach”. And so we see the introduction of the concept of “commercial justification” for the amount of liquidated damages providing it is in the context of compensation for breach and not a deterrent to breach.
Lordsvale was considered and approved in the Court of Appeal case of Cine Bes Filmcilik ve Yapimcilik –v- United International Pictures  EWCA Civ 1669. This case concerned a licence agreement for the distribution of films. Two clauses in the licence agreement were relevant: clause 16 and the “AB amount” being an amount payable by Cine to United in respect of advertising and barter time and clause 17 being United’s right of termination and to recover its termination costs, including legal costs associated with termination.
The licence agreement was terminated by United who then made a claim, including for the AB amount and its legal costs of termination. Cine argued clause 16 and 17 were penalties and unenforceable.
Lord Justice Mance said “I have also found valuable Colman J’s further observation in Lordsvale … which indicate a dichotomy between a genuine pre-estimate of damages and a penalty does not necessarily cover all the possibilities. There are clauses which may operate on breach, but which fall into neither category, and may be commercially perfectly justifiable”.
In Azimut-Benetti Spa –v- Healey  EWHC 2234 the court held that the liquidated damages payable to Azimut-Benetti (20% of a EUR 38m the purchase price) on termination of a contract between Azimut-Benetti as builder and the purchaser of a luxury yacht was not penal. The court accepted the liquidated damages clause “objectively regarded, … had a clear commercial and compensatory justification … The clause is plainly not a deterrent …”.
The simplified facts of El Makdessi v Cavendish Square Holdings  EWCA Civ 1539 are as follows. Cavendish purchased an interest in Makdessi’s company, an advertising company in the Middle East. Makdessi became a “Defaulting Seller” under the sale and purchase agreement which triggered two clauses. Under clause 5.1, the effect was to withhold from Makdessi $44,181,600.00 otherwise payable to Makdessi by Cavendish. Under clause 5.6, the effect was to force Makdessi to sell shares based on the Net Asset Value which ignored the value of the goodwill in the business again substantially deflating what was payable to Makdessi by Cavendish. Makdessi argued these clauses were penal.
At first instance the court accepted the commercial justification argument. On appeal Clarke LJ (at 117) held “… the clauses, taken in the context of the Agreement as a whole, are not genuine pre-estimates of loss. On the contrary they are extravagant and unreasonable”. However he went on to say: “That is not necessarily conclusive. A commercial justification may mean that a clause which is not a genuine pre-estimate is not penal”. On the facts of the case, the court found the clauses were not commercially justifiable but were rather designed to act as a deterrent and therefore penal. At 121: “The payment terms of clause 5.1 and 5.6 do not serve some justifiable commercial or economic function … Their effect is Mr Makdessi stands likely to forfeit sums in tens of millions …”.
The case of ParkingEye Limited –v- Barry Beavis  EWCA Civ 402 concerns Mr Beavis’ £85 car parking fine, as a result of overstaying a permitted period of free parking by nearly 1 hour.
Mr Beavis argued the fine was a penalty and not a genuine pre-estimate of loss because if he had vacated the car parking space at the correct time, it would either (i) have remained vacant or (ii) been occupied by another car for a period of free parking. Either way, ParkingEye would not have suffered loss of £85. The fine was not a genuine pre-estimate of loss but rather it was a deterrent.
This was accepted by the court at first instance - the fine had the characteristics of a penalty. However, the fine was upheld on the grounds that it was commercially justifiable because it was not improper in its purpose or manifestly excessive in amount.
On appeal Lord Justice Moore-Brick said at 21 “The modern cases thus appear to accept that a clause providing for the payment on breach of a sum of money that exceeds the amount that a court would award as compensation … may not be regarded as penal if it can be justified commercially and if its predominate purpose is not to deter breach”. At 27 “…that the court will not enforce any agreement for the payment in the event of breach, an amount which is extravagant and unconscionable, despite the importance which would normally attach to enforcing contracts freely entered into…the fact that the contract provides for the payment on breach of a sum which significantly exceeds the greatest loss that the law would recognise as having been suffered by the injured party is in most circumstances a strong indication that the bargain is extravagant and unconscionable, but other factors may be present which rob the bargain of that character. Those factors may be of a commercial nature…in the present case it is possible to present the charges, as the judge did, as commercially justifiable but in truth, they are justified by a combination of factors social as well as commercial”.
THE SUPREME COURT
Both Cavendish and Beavis obtained leave to appeal to the Supreme Court, it recognising that it was time the doctrine of penalties be considered in the context of the modern world. Both appeals were heard together with the judgment being given today, 4 November 2015.
The court has not only looked at the issues in dispute in both appeals but also at the law relating to penalties and their unenforceability; the origins and development of the doctrine and the extent to which it should be abolished in commercial cases or restricted to non-commercial cases where the parties are unequal in their bargaining power or there is a risk of oppression or cases involving payment of money.
In a long judgment spanning some 123 pages their Lordships made a number of important points and most importantly, how a sum should be assessed to decide whether it is a penalty or not. In the Judgment their Lordships:
- Unanimously rejected the Makdessi challenge that clause 5.1 and 5.6 were penal and in a majority, rejected the Beavis challenge that the £85 fine was penal.
- Accepted in both Cavendish and Makdessi that the challenged provisions legitimately protected more than predicted financial loss. There was a legitimate commercial justification for the provisions which went beyond the recovery of a genuine pre-estimate of loss.
- In Cavendish as per Lord Neuberger and Lord Sumption, (at 75) Cavendish “had a legitimate interest to protect which extended beyond the recovery of loss” and the parties “who were, on both sides, sophisticated, successful and experienced commercial people bargaining on equal terms over a long period of time with expert legal advice and were the best judges of the degree to which each of them should recognise the proper commercial interests of the other”. And (at 82) “… the price formula in clause 5.6 had a legitimate function which had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective in acquiring the business. And, like clause 5.1, it was part of a carefully constructed contract which had been the subject of detailed negotiations over many months between two sophisticated commercial parties, dealing with each other on an equal basis with specialist, experienced and expert legal advice”. As per Lord Mance (at 181) “On this basis, the question still remains whether clause 5.1 can and should be condemned as penal on the grounds that it is extravagant, exorbitant or unconscionable in its nature and impact. … I have come to the conclusion that, in this particular agreement made deliberately and advisedly between informed and sophisticated parties, the court should answer the question in the negative… Its effect was to revise the basic price calculation for the shares which it had been agreed to be sold, and, so viewed in the context of a carefully negotiated agreement between informed and legally advised parties at arm’s length, I do not consider it can or should be regarded as extravagant, exorbitant or unconscionable”. As per Lord Hodge (at 278) “In summary, I am persuaded that in the circumstances of this share purchase, Cavendish had a very substantial legitimate interest to protect by making the deferred consideration depend upon the continued loyalty of the sellers through their compliance with the prohibitions in clause 11.2. I do not construe clause 5.1 as a stipulation for punishment for beach; it is neither exorbitant nor unconscionable but is commensurate with Cavendish’s legitimate interests”.
- In Beavis as per Lord Neuberger and Lord Sumption (at 98) “… it can be seen that the £85 charge had two main objects. One was to manage the efficient use of parking space so the interests of the retail outlets, and of the users of those outlets … The other purpose was to provide an income stream to enable ParkingEye to meet the cost of operating the scheme … These two objectives appear to us to be perfectly reasonable in themselves. … In our opinion, while the penalty rule is plainly engaged, the £85 charge is not a penalty. The reason is that although ParkingEye was not liable to suffer loss as a result of overstaying motorists, it had a legitimate interest in charging them which extended beyond the recovery of any loss. … As we have pointed out, deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract”. As per Lord Mance (at 199) “In these circumstances, the fact that no individual episode of overstaying … could be said to involve ParkingEye … in any ascertainable damages is irrelevant. What matters is that a charge of the order of £85 … is an understandable ingredient of a scheme serving a legitimate interest”.
- Rejected the Cavendish submission that the rule that a penalty is unenforceable be abolished or amended. The reasoning included: it is a rule common to many other major systems of law and there remains significant imbalances in negotiating power in the commercial world.
CONCLUSIONS AND PRACTICAL TIPS
- The rule that a penalty is unenforceable is still good law in England and Wales.
- The test as to whether a sum is a penalty is no longer the genuine pre-estimate of loss for so long regarded as good law but rather (as per Lord Neuberger and Lord Sumption at 32) whether the “… provision imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party …”.
- Liquidated damages need no longer be solely a reflection of a genuine pre-estimate of loss but can reflect the wider commercial context of a transaction and seek to protect legitimate commercial interests provided always that the amount of the liquidated damages is not extravagant, exorbitant or unconscionable.
- It is arguable that the protection of a legitimate commercial interest is limited to “commercial cases” or where the parties are “bargaining on equal terms” or represented by lawyers. This is a point that is likely to be the subject of further judicial consideration in the future.
- The prudent party seeking to include a liquidated damages provision in a contract will now keep an explanation of the amount of the liquidated damages and why it represents a reasonable and proportionate protection of a legitimate commercial interest.