A new test for penalties

The Supreme Court has reached a decision on whether the rule against penalty clauses ought to be abolished, broadened, restricted or better codified. While the Supreme Court doubted “that the courts would have invented the rule today if their predecessors had not done so three centuries ago” it decided that judicial abolition would not be a proper course to take and that it would better codify the “test” for when a contractual provision is a penalty.

The new test is: a contractual clause is penal if it was a secondary obligation which imposed 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. 

In the context of a typical construction contract the test may be expressed as: a so-called liquidated damages clause for delay to completion is an (unenforceable) penalty if it imposes a number (£x/day) on the contractor that is out of all proportion to any legitimate interest of the employer/owner/developer in achieving the target completion date. 

The Supreme Court has removed reliance on commercial purpose as an excuse for inserting what would otherwise be a penalty

Readers may think there is no real difference between the new test and how the industry has applied the so called Lord Dunedin test, as set out in the 1915 case of Dunlop Pneumatic Tyre Company Ltd vs New Garage and Motor Company Ltd. Such readers would be correct and indeed the Supreme Court recognises that in the case of a straightforward damages clause (as in typical building contracts), the employer’s interest would rarely extend beyond compensation for the breach, and their lordships would expect that Lord Dunedin’s four tests would usually be adequate to determine validity. A lazy reader could stop here and presume that the Supreme Court’s decision has changed nothing for the construction industry. 

However, where monetary compensation was not the only legitimate interest which the innocent party might have in the performance of the defaulter’s primary obligations, the new test makes several subtle adjustments. First, it removes debate on whether the sum stated to be the liquidated damage was a genuine pre-estimate of the loss that the employer would suffer as consequence of a delay to completion. Second, it removes debate on whether the clause was inserted as a deterrent. Third, the Supreme Court has removed reliance on commercial purpose as an excuse for inserting what would otherwise be a penalty. 

In many non-construction agreements – for example, a share purchase agreement – a buyer of the company may have a legitimate interest in the performance by the seller which extends beyond the recovery of pure monetary compensation, and it is in such situations that the new test will really take effect.

This is exactly what happened in the Cavendish Square Holding BV vs Talal El Makdessi case. Readers may recall my earlier article where I discussed that, by an agreement, Mr Makdessi agreed to sell to Cavendish a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. The contract provided that if he was in breach of certain restrictive covenants against competing activities, Mr Makdessi would not be entitled to receive the final two instalments of the price paid by Cavendish (clause 5.1) and could be required to sell his remaining shares to Cavendish, at a price excluding the value of the goodwill of the business (clause 5.6).

The issues will not be so binary and one can expect courts to look at the overall contractual arrangements

Mr Makdessi subsequently breached these covenants. Mr Makdessi argued that clauses 5.1 and 5.6 were unenforceable penalty clauses. The Supreme Court has decided that the law of penalties did not apply because the clauses in question were effectively price adjustment clauses and as such part of the primary commercial deal in which the courts cannot interfere. 

This is where construction lawyers may get excited, or “innovative”, and seek to draft contracts so that the contract sum could be reduced if, for example, the contractor fails to achieve certain key performance indicators. Such drafters would seek to argue that the adjustment of the contract sum in accordance with KPIs is all part of the primary obligation relating to the contract sum and thus nothing to do with the law on penalties relying on the statement that “it is not a proper function of the penalty rule to empower the courts to review the fairness of the parties’ primary obligations, such as the consideration promised for a given standard of performance”. 

However, the issues will not be so binary and one can expect courts to look at the overall contractual arrangements or context to assess whether things like failure to achieve KPIs were properly a material or fundamental aspect of the commercial bargain. Such issues will require elegant and bespoke legal analysis.

Hamish Lal is head of construction at Jones Day London