In our last newsletter1 we discussed the basic principles of liquidated damages clauses. Under English law, there are certain limited circumstances in which a liquidated damages clause may be unenforceable. We will now look at when liquidated damages clauses may be deemed to be unenforceable penalties and the practical considerations to be had before running a penalty argument.

The Dunlop test

The general principle under English law is that agreements freely entered into should be enforced. The notion of a penalty is an exception to this rule. This exception has arisen largely to protect parties from being held 'in terrorem' (literally meaning 'in fear') of breaching the agreement. The distinction between an enforceable liquidated damages provision and an unenforceable penalty is sometimes seen as the distinction between a fixed payment that is "essentially compensatory in nature" and one which is there to "deter the party in question from breaking the contract by providing for a punitive level of payment"2.

The classic test of whether a sum payable on breach is a penalty was formulated in the 1915 case of Dunlop Pneumatic Tyre v New Garage & Motor3: a sum is not a penalty if it represents a "genuine covenanted pre-estimate of damage". This means that the clause will be enforceable if the sum was considered by the parties at the time of entering into the contract to be a genuine pre-estimate of the loss that might be incurred as a result of the breach in question.

The courts have approached the Dunlop test from different perspectives: some considering whether there was an extravagant or unconscionable disproportion between the level of damages stipulated in the contract and the actual amount of damages likely to be suffered, and in other cases the courts considered whether the level of damages was reasonable. Jackson J reconciled these approaches in the more recent case of Tilebox4 stating that, in order for an agreed pre-estimate to be found to be unreasonable, "there must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered".

What does 'genuine' mean? The case law is clear that it does not have to mean honest or indeed accurate5. The key question is whether the agreed liquidated damages sum was an estimate of the likely loss to the employer arising as a result of the breach, rather than a deterrent. Although the test is an objective one, the courts may take into account the thought processes of the parties at the time of contracting in agreeing the rate of liquidated damages, which would of course introduce a subjective element to the test. The courts will place little, if any, reliance on express wording in the contract claiming that the clause is not a penalty.

Importantly, so long as the liquidated damages provision is found to be a genuine pre-estimate of loss, it is irrelevant to consider whether there is any loss. Therefore, an employer will be able to recover the contractual liquidated damages even if ultimately it suffers no actual loss6.

The distinction between unenforceable penalties and liquidated damages in practice

It can sometimes be hard to distinguish between a penalty and a genuine pre-estimate of loss. Difficulties can arise because parties often do not know at the time of signing the contract what the likely losses, or range of likely losses, will be and will therefore simply negotiate a commercially acceptable figure. Also, and particularly where it expects to be late in completing the works, the cont ractor may have factored the liquidated damages into its bid price so that, although the liquidated damages might appear to be excessive, they are offset by the higher contract price.

In some cases the parties may greatly overestimate the losses, with the result that the contractual rate of liquidated damages appears penal when compared to the (much lower) actual losses. Indeed, as the Privy Council pointed out in Phillips Hong Kong7, there may be a range of scenarios in which the actual loss will be lower than the contractual sum, but this will not in itself invalidate the contractual provision; parties cannot be expected to be able to envisage every such scenario and estimate the losses for each.

In practice, a sum is unlikely to be penal unless it falls into one or more of the following categories:

  1. The sum is "extravagantly or unconscionably disproportionate"8 to the greatest possible loss likely to be suffered. The case of Commissioner of Public Works v Hills9 concerned a construction contract which provided that the contractor would forfeit retention monies as and for liquidated damages for late completion. It was held that this could not be considered to be a genuine pre-estimate of loss as the sum would increase with no relation to the cost of completion. Indeed, retention monies ordinarily increase as the cost of completing the works decreases.
  2. Where a flat rate is payable whatever the seriousness of the breach. Examples are where the same liquidated damages are to be payable irrespective of the length of the delay to completion, or where the contract provides that the workscan be completed in sections but there is no corresponding mechanism for scaling down the liquidated damages once one or more sections have been handed over10.
  3. The same liquidated sum is payable for different breaches, some serious, some trivial11.  

Practical considerations

While the penalty defence is frequently raised it is rarely successful. This is particularly so in construction disputes. The courts tend to follow the maxim, expressed in Tilebox, that "because the rule about penalties is an anomaly within the law of contract, the courts are predisposed, where possible, to uphold contractual terms which fix the level of damages for breach. This predisposition is even stronger in the case of commercial contracts freely entered into between parties of comparable bargaining power." Contractors should therefore be wary of placing too much reliance on a penalty argument.

That said, there will be cases where the contractor has good grounds for claiming that the liquidated damages clause is a penalty and unenforceable. However, a successful challenge to a penalty does not provide an escape from liability. Even if a contractor is successful in arguing that a liquidated damages clause is a penalty this will not extinguish the contractor's liability in damages to the employer for its breach. The employer may still recover any actual losses that it can prove it incurred by suing for general (unliquidated) damages.

Nonetheless, in some cases the employer's actual losses will be less than the sum agreed in the contract thereby reducing the contractor's liability. Even if they are not, proving actual loss can be difficult. An employer may be willing to agree to accept a lower sum as part of a negotiated settlement rather than spending time and costs lower sum as part of a negotiated settlement rather than spending time and costs demonstrating its actual losses. There can therefore be considerable tactical advantages to the contractor in running a penalty argument, even if a successful result is uncertain.

Finally, while a tribunal may treat the penalty as guidance when considering the maximum allowable damages for the breach in question, it is possible that general damages could be nearly as high as, or even higher than, the contractual sum. At first this may seem counterintuitive: how can the contractual sum be penal if it is less than the actual loss? However, in scenarios (b) and (c) above, the liquidated damages provision may found to be penal simply because of the way it is calculated or expressed, even though it is lower than the loss actually sustained. An employer in those situations may be able to persuade a court or tribunal that the level of the penalty should be ignored when calculating its award on damages. There is, however, no definitive view under English law as to whether such an argument would be successful.

Conclusion

Even though penalty arguments are rarely upheld, there can be considerable tactical advantages in raising the defence. Nonetheless, contractors should be wary of placing too much reliance on a penalty argument: it will not extinguish a contractor's liability for breach of contract and may not necessarily reduce the value of the claim. In the next issue of this newsletter we will examine other grounds for challenging a contractor's liability to pay liquidated damages for delay, including where liquidated damages clauses are held to be void for uncertainty and where the contractor has left site without completing the works.