It is better to know the extent of your liability under a contract if/when the project does not go swimmingly. You can pre-agree the damages to be paid to your (innocent) partner. But will the courts uphold that amount or interfere with your freedom of contract?
There are many cases in which the courts have debated its role in messing with your agreement. This blog looks developments since the classic case of Dunlop v New Garage.
Under the default position, if partner A breaches its contract with partner B, then A is liable to compensate B for losses caused by that breach.
the paradigm case in which the law of penalties is engaged is where a party agrees that, upon a breach of contract, he will pay the innocent party a sum of money [Makdessi v Cavendish, Court of Appeal]
Liquidated damages are fixed damages set out in the contract which are meant to make it simpler and quicker to recover losses when your partner commits a breach. They are not perfect, but the English courts are doing their best to uphold them as ‘available as of right’ without the need for court proceedings.
When to Use Liquidated Damages
Construction and engineering contracts typically include a clause allowing B to claim a specific sum of money (or percentage of the contract price) when A commits a particular breach of contract.
In construction contracts, A will typically pay B money (agreed damages) for breaching the contract by completing the project late, often a fixed sum per week of delay. These are known as liquidated damages, liquidated and ascertained damages, or delay damages.
PS Liquidated means known. Ascertained means based on the contract terms.
In engineering contracts, A will typically pay B agreed damages for breaching the contract when the completed works do not meet the required standards of performance, often a percentage of the contract price for that element of the plant.
Liquidated damages can be used for all sorts of other breaches including failure to privide the programme (NEC4), failure to provide a bond or guarantee, failure to provide completion documents, failure to provide a payment application in the correct format or failing to meet a target internal floor area.
Can It Be a Penalty?
In Workers Trust v Dojap, the court explained why it interfered with these type of clauses:
In general a contractual provision which requires one party in the event of his breach of contract to pay or forfeit a sum of money to the other party is unlawful as being a penalty, unless such provision can be justified as being a payment of liquidated damages being a genuine pre-estimate of the loss which the innocent party will incur by reason of the breach.
For years contractors argued that the sums were a penalty and they did not have to pay. Only four cases succeeded – another defence is that the contractor is entitled to an extension of time, and this is now the only real option…
The Supreme Court decision in ParkingEye v Beavis said this of the rule on penalties:
The penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well, and which in the opinion of some should simply be demolished, and in the opinion of others should be reconstructed and extended.
Any contractor arguing that the liquidated damages are a penalty is likely to get short shrift from the judges.
You can state in your contract a level of pre-agreed damages the innocent partner can recover. This saves the time to determine your losses, court costs in pursuing a claim for breach of contract, and often acts as a cap on liability. It benefits both partners to the contract. It is better to put a figure in for delay or other breach, however tentative, than suffer the vagaries of proving your losses in court or adjudication.
One defence is to claim that the level of damages is a penalty – which English law prohibits. The Dunlop case set out some factors to take into account
- the words used are not conclusive – your terminology will not affect the court’s view
- the essence of a penalty is an amount of money intended to deter your partner from offending
- the essence of liquidated damages is a genuine pre-estimate of damage
- it will be a penalty if it is extravagant or unconscionable in comparison with the greatest possible loss.
The court also said that:
“It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.”
The courts’ approach is to support the level agreed. This provides certainty for the parties and prevents unnecessary court interference in contracts between savvy businesses.
No More Nit-Picking
Since the Dunlop case, lawyers sought “hypothetical situations where the effect of the application of the clause may be to produce a sum payable to the employer substantially in excess of the damage which the employer is likely to suffer.” [Philips v AG Hong Kong]
But the courts have countered with:
- “… so long as the sum payable in the event of non compliance with the contract is not extravagant, having regard to the range of losses that it could reasonably be anticipated it would have to cover at the time when the contract was made, it can still be a genuine pre-estimate of the loss that would be suffered and so a perfectly valid liquidated damage provision. The use in argument of unlikely illustrations should therefore not assist a party to defeat a provision as to liquidated damages.” [Philips v AG Hong Kong]
- “what the parties have agreed should normally be upheld. Any other approach will lead to undesirable uncertainty in commercial contact.”
- “Both parties had the benefit of expert representation in the conclusion of the contract. The terms, including the liquidated damages clause, were freely entered into… in a commercial contract of this kind, what the parties have agreed should normally be upheld.” [Azimut-Benetti v Healey]
- The court “recognises the utility of liquidated damages clauses and that to hold them to be penal is an interference with freedom of contract. It is, therefore, predisposed to uphold clauses which fix the damages for breach.” [Makdessi v Cavendish, Court of Appeal]
- “A pre-estimate does not have to be right to be reasonable.” [Makdessi v Cavendish, Court of Appeal]
- “The true test is whether the [level of LADs] imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party…” [Makdessi v Cavendish, Supreme Court]
The present position is really that where you negotiate a contract then you are the best judge of the right level of delay damages and the courts will be very slow to interfere.
The only basis on which you can claim that the delay damages are a penalty and therefore unenforceable is if they are “extravagant and unconscionable comapred to the greatest loss that the innocent party may suffer arising from your breach”. A high hurdle indeed!
For a summary of the law on penalties, the cases discussed above and the current law, see Cavendish Square Holding BV v Talal El Makdessi (Rev 3)  UKSC 67
Updated July 2018