LADs and penalty clauses – important reading for all associated with the construction industry

The Supreme Court has issued important guidance on how and when contractual clauses (such as liquidated and ascertained damages (LADs)) will be upheld and when they will be considered unenforceable penalty clauses.

The case is of significance for all those involved in the construction industry, among others. It develops and clarifies the factors the court will consider when reviewing LADs and those involved in negotiating LADs will wish to bear this fresh approach in mind.

Background

Parties to construction contracts frequently elect to set the level of damages to which an employer is entitled in the event of the contractor breaching specified provisions of the contract, for instance the contractor’s failure to complete the works by a specified completion date. A pre-determined sum (or formula to reach such a sum) to be paid by the contractor in the event of such a breach is then incorporated into the contract. Such sums are known as LADs and are generally seen as beneficial by contracting parties in allowing certainty about the consequences of a breach.

The principal ground for a challenge to LADs clauses had long been understood to be that the liquidated damages payable did not represent a “genuine pre-estimate” of the loss that the employer would actually suffer for delay. If they did not, then the clause would be a penalty and unenforceable (Dunlop Pneumatic Tyre Limited v New Garage & Motor Company Limited [1915] AC).

The decision

The Supreme Court has recently undertaken an analysis of the law in this area, in two appeals. The first appeal concerned a commercial share sale agreement (Cavendish Square Holding BV v Talal El Makdessi [2015] (UKSC 67)) and the second, a consumer parking fine dispute (ParkingEye Limited v Beavis [2015] (UKSC 67)).

The Supreme Court said that contracting parties had become unduly confined by the analysis above. In the words of the main judgement (emphasis added):

“The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss ……… The question whether it is enforceable should depend upon whether the means by which the contracting party’s conduct is to be influenced are “unconscionable” or (which will usually amount to the same thing) “extravagant”…”

In a significant change of emphasis the Court held that:

“The true test is whether the impugned provision [i.e. the LAD clause]………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 [i.e. the obligation to complete the Works on time]. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance”.

The Court has therefore moved away from an analysis based on whether there has been a “genuine pre-estimate of loss”.

The test now is whether:

• The liquidated damages clause is designed to protect a “legitimate interest”;
• If it is, the clause will be upheld if the protection is not out of all proportion to the interests being protected and is not “extravagant” or “unconscionable”.

Comment

The decision is likely to have a day-to-day impact for the construction industry in how LAD clauses are negotiated. Employers will wish to emphasise their legitimate interest in imposing LADs at a pre-arranged level while contractors may wish to portray setting LADs at a high level as unconscionable.

Parties may also wish to reconsider the wording of clauses such as:

• “The parties hereby agree that the figure of [£x] is a genuine pre-estimate of the Employer’s probable losses for delay”.

To the extent that any such clauses are effective at all, they should now be redrafted to reflect the new version of the test.

LADs will remain an important mechanism for regulating risk within the construction industry. Contracting parties should though be aware that how the Courts analyse such clauses has now significantly shifted.