The Supreme Court's reformulation of the English law test for penalties in 2015 created a degree of uncertainty in the construction industry, with many unsure how the test would now operate when applied to delay liquidated damages clauses. A recent decision, one of the first construction cases applying the new test of legitimate interest rather than genuine pre-estimate of loss, is a step forward in addressing this uncertainty and provides useful guidance on how English law will approach delay liquidated damages provisions. With English law remaining a very popular choice of governing law for construction contracts in the Middle East, the recent decision in GPP Big Field LLP and Anor v Solar EPC Solutions SL will be of interest to employers and contractors here alike.
Recap of the rule on penalties established in Makdessi
In 2015, England's Supreme Court reformulated the rule on penalties under English law from the longstanding "genuine pre-estimate of loss" test, established more than 100 years ago in Dunlop v New Grange, into the "legitimate interest" test with its ruling in Cavendish Square v Makdessi. The focus of the test following Makdessi is now whether the sum or remedy specified as a consequence of a breach of contract is exorbitant or unconscionable when viewed in the context of the innocent party's legitimate interest in the performance of the contract. There could, of course, be a legitimate interest to be protected even if no loss was foreseeable when the contract was signed.
The question of the proper application of this penalty doctrine is most frequently raised in construction disputes via challenges to provisions for liquidated damages for delay. GPP Big Field helps to explain how the courts will apply the new test in Makdessi in construction disputes, and provides considerable assurance that such clauses will be given effect as the parties expected.
Facts of GPP Big Field
GPP (the "Employer") engaged Prosolia UK Ltd (the "Contractor") under separate EPC contracts to construct five solar plants throughout the United Kingdom. The contracts proved unprofitable for the Contractor, leading to the Contractor's insolvency. The Employer, then brought a claim against Solar, the Contractor's parent company (the "Parent Company") for liquidated damages for delay arising as a consequence of the Contractor's late completion and/or non-completion of the works under four of the EPC contracts.
The Parent Company raised various defenses to the liquidated damages claims, including claiming that there was a force majeure event and that the Parent Company's liability had been released by a variation of the EPC contracts made without its consent. However, for our purposes, the most interesting discussion focused on the claim that the delay liquidated damages clauses in the EPC contracts were unenforceable as penalties.
Application to the Delay Liquidated Damages provisions
Despite the fact that each of the plants had a different output and different expected electricity prices, with these varying by as much as 30%, each EPC contract contained the same fundamental liquidated damages clause that:
"In the event of delay... The Contractor shall pay to the [Employer] a penalty... of 500 per day per MWp installed... per day that the construction works suffer delay. The maximum penalty for delays of the Works shall be two hundred and fifty thousand pounds sterling per MWp (250,000/MWp)."
The Employer claimed liquidated damages for delay under the relevant clause under four of the EPC contracts. However, the Parent Company contended that the delay damages provisions were unenforceable as penalties. It argued that the use of the same round figure for different plants with different electricity prices, when actual losses would depend on a combination of factors, showed that the sum specified could not be a genuine pre-estimate of loss.
In finding that the delay damages provided for did not constitute a penalty and were, therefore, enforceable, the Court noted that:
- Liquidated damages provisions of the kind found in the EPC contracts are common in construction contracts.
- The parties were experienced and sophisticated commercial parties of equal bargaining power, who were capable of assessing the commercial implications of the liquidated damages provisions when negotiating the contracts.
- The Employer did have a legitimate interest in ensuring that the plants were commissioned on time, as it was acquiring the plants as long-term investments on the basis of financial modelling which used the contractual start dates.
- The value of liquidated damages under each contract may have been a round sum which would be due irrespective of the effect of the delay in question; however this is common for liquidated damages clauses which are often used when precise prediction of the likely loss is difficult and is not, therefore, decisive in the question of whether a genuine pre-estimate of loss has been made.
- The fact that the loss resulting from the breach which triggers liquidated damages payments may vary in amount, depending on the actual circumstances at the time, does not give rise to any inference that the sum agreed to be paid is a penalty, provided that the sum specified is not extravagant and unconscionable when compared with the greatest loss that might have been expected as likely to flow from that breach when the contract was made.
The Court also rejected the argument that the use of the word "penalty" in the clause was a "powerful indicator" that the clause was intended to act as a punitive measure. Instead, it found that use of the term "penalty" was not determinative and one must look at the substance of the clause.
Finally, in arriving at its decision, the court did consider the "genuine pre-estimate of loss" test from Dunlop, demonstrating that this has not been rendered invalid by Makdessi. In most cases, liquidated damages which are a genuine pre-estimate of loss will be protective of the innocent party's legitimate interest. So whether liquidated damages are a genuine pre-estimate of loss remains a relevant consideration, but one which is taken into account in a broader framework than provided for under the previous test.
As the Court said the clause was enforceable as it was 'satisfied that the sum specified in clause 21.5 does not exceed a genuine attempt to estimate in advance the loss which the [Employer] would be likely to suffer from a breach, and that that sum is not in any way extravagant or unconscionable in comparison with the legitimate interest of the [Employer] in ensuring timely performance.'
GPP Big Field demonstrates that, despite the change in English law on penalties, delay liquidated damages clauses in construction contracts will continue to be enforced, and the law will not take a pedantic or highly legalistic approach to them. The amount claimed under the clause is still important and, provided that the amount to be paid is not unconscionable or extravagant when compared with the employer's legitimate interest in having works delivered on time, that clause will be enforced. The employer's pre-estimated losses are relevant in identifying those legitimate interests, but there does not necessarily need to be an exact match between the pre-estimate and the amount of liquidated damages claimed. This highlights the increasing difficulty in challenging liquidated damages clauses under English law, and will be welcomed by employers. However, it may provide contractors with pause for thought prior to agreeing to the amount of delay liquidated damages or seeking to challenge such clauses' application.