A yellow card for penalties?

During the negotiation of construction contracts a common query is what remedies are available for breach and how such provisions should be drafted. This being particularly relevant when “liquidated damages” provisions can entitle the innocent party to claim stipulated sums upon the occurrence of a specified default, usually culpable delay to the works, without having to prove actual loss.

The commercial benefit and convenience of such provisions has led to their widespread use in all kinds of construction and commercial contracts. As the financial impact of levying substantial liquidated damages is so severe, the use of these provisions has also led to a body of case law where parties in breach have tried to escape the consequences - the only way out being by successfully arguing the clause was an unenforceable penalty. However, the application of the penalty rule was seen as a blatant interference with the freedom to contract and not only that, out dated and unclear.

Therefore, when two cases on liquidated damages were heard together in the Supreme Court, it seemed possible that the law on penalty clauses was to receive its biggest shake-up in one hundred years courtesy of Cavendish Square Holdings BV vs Talal El Makdessi and ParkingEye vs Barry Beavis.

Under the previous test in Dunlop Pneumatic Tyre Company Ltd vs New Garage & Motor Company Limited [1915] AC 79, clauses imposing a sanction for breach that did not constitute a genuine pre-estimate of the loss that would be suffered, that were extravagant or unconscionable in amount with a sole function of deterrence, were presumed to be an unenforceable penalty.

However, this century-old rule came in for considerable criticism with the Supreme Court noting that “the penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well”.

The facts of the two cases would struggle to be more different: Cavendish concerned the sale of an advertising company where Mr Makdessi, the founder, was to sell part of his shares to a holding company.

The contract provided for stage payments, with one clause stating that if a seller were to become a “defaulting shareholder”, he would not be entitled to the agreed payment and his shares would instead be sold at a much lower price that took no account of the significant goodwill attached to the company. Mr Makdessi admitted that he was a defaulting shareholder by way of breach of certain restrictive covenants, but argued that the consequences were penal and therefore unenforceable.

The century-old rule came in for considerable criticism with the Supreme Court noting that ‘the penalty rule in England is an ancient, haphazardly constructed edifice which has not weathered well’

ParkingEye, in sharp contrast, related to a charge of £85 levied for Mr Beavis’ overstay beyond the two-hour free parking which it was argued was solely designed as a deterrent and not a genuine pre-estimate of loss.

In both cases, the clauses were not genuine pre-estimates, so if Dunlop were to be followed, they would potentially be a penalty, acting as a deterrent to breach. The judicial reasoning of the past hundred years had suggested that clauses were either a genuine pre-estimate or a penalty. However, what became evident when the Supreme Court analysed the recent case law was the movement away from the dichotomy between penalty and genuine pre-estimate of loss relying instead on the commercial justification of such clauses and allowing them to stand as long as their primary purpose was not to deter.

While it was found that Cavendish did not engage the penalty rule as the relevant clauses were categorised as “withholding and transfer of property clauses” the clauses were not penal in any event because each clause had a commercial purpose that was not oppressive or unconscionable. In any event, the case still highlighted the difficulty in distinguishing between what may be categorised as legitimate, commercial justification and a sole deterrent intent. In confronting this “artificial categorisation”, the Supreme Court decided against extending the rule on penalties – a relief to most practitioners – but it would not go so far as to abolish the rule altogether.

Instead, penalties were given a yellow card as the concept of a penalty and a pre-estimate of loss were not in fact mutually exclusive.

In a similar vein, while the consequences of breach for Mr Beavis did not constitute a genuine pre-estimate of the loss to ParkingEye, this did not automatically mean the clause was penal. The legitimacy of clauses operating on breach did not depend on bearing any relation to the damages that would be awarded by the courts. Instead, it was accepted that such clauses could be justified by wider commercial considerations. In this case the interest being to encourage the prompt turnover of parking spaces to the benefit of ParkingEye’s client, the owners of the nearby retail park.

So now, the true test of a penalty is whether the clause “is a secondary obligation which 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”.

What does this mean for construction? Importantly, contractual deterrents can now be enforced by reference to a legitimate interest in the performance of the contract.

Stephanie Canham is head of construction at law firm Trowers & Hamlins