Refs to review penalties

A hundred years ago the House of Lords, in Dunlop Pneumatic Tyre Co Ltd vs New Garage and Motor Co, summarised when a clause, which specified a predetermined sum payable in the event of a breach, would be enforceable and when it would be considered a penalty. The construction industry has of course made significant use of this principle with genuine pre-estimates of loss forming enforceable liquidated damage provisions. Where the size of the liquidated damage is large, we have also seen arguments that the provision is a penalty and therefore unenforceable.

Is the law on liquidated damages too uncertain or unpredictable or unworkable? Is now the right time to abandon this law? Such questions often trouble clients when they are seeking to set the “correct” and “commercially acceptable” level of liquidated damages. The Supreme Court of the United Kingdom has been asked to look at penalty clauses – its decision may have fundamental consequences for the entire construction industry.

Is the law on liquidated damages too uncertain or unpredictable? Is now the right time to abandon this law? Such questions often trouble clients when they are seeking to set the ‘correct’ level of liquidated damages

A judicial bench of seven justices of the Supreme Court are currently deciding whether the rule against penalties ought to apply to commercial contracts between sophisticated parties (such as, for example, a developer and a main contractor). This appeal arises from Cavendish Square Holdings vs Makdessi but is being heard alongside ParkingEye Limited vs Beavis. In this latter case the appellant drove into a car park managed by ParkingEye. Prominent signs stipulated that the maximum stay was two hours after which a parking charge of £85 would be payable (reduced to £50 if paid within 14 days). The appellant stayed for nearly three hours and was charged £85, which he refused to pay. The Supreme Court has to decide whether a charge of £85 for exceeding a maximum car parking period is an unenforceable penalty or whether such a charge is unfair under the

Unfair Terms in Consumer Contracts Regulations 1999. The cases are at opposite ends of the commercial dealing spectrum but both have significant consequences for sophisticated parties and consumers.

It is worth noting the facts in Cavendish: Makdessi agreed to sell a controlling stake in what became the largest advertising group in the Middle East to Cavendish. Makdessi conceded that, if enforceable, he breached restrictive covenants in the agreement. As a result, under a clause in the agreement he would forfeit the final two instalments of deferred consideration payable by Cavendish for his shares and under another clause he would be required to transfer all of his remaining shares to Cavendish at a price which excluded any value referable to so-called goodwill. Makdessi said that these clauses were unenforceable penalties. The Court of Appeal agreed.

If it is decided that the rule against penalties is not applicable to commercial contracts between sophisticated parties, then developers would be free to insert very large sums as liquidated damages

The decision of the Supreme Court is perhaps one of the most important ever in the context of the common law and construction law. If it is decided that the rule against penalties is not applicable to commercial contracts between sophisticated parties, then developers would be free to insert very large sums as liquidated damages – but would contractors agree? Could we see a switch from liquidated damages to general damages?

Other irresistible questions include: when is a party not a “sophisticated party” – for example, a main contractor and a large subcontractor are likely to be sophisticated but what if the subcontractor is a level of magnitude smaller than the main contractor?

Even if the Supreme Court does not go so far as to say that the rule against penalties does not automatically apply to commercial contracts between sophisticated parties, the court is likely to discuss the so-called “modern test” which looks at whether there is good commercial justification. Here the courts have looked at three overlapping issues – proportionality to actual loss; deterrence; and commercial justification – to decide if the clause is so extravagant, unconscionable and unjustifiable that the courts will not give effect to it.

Lawyers, developers, contractors, consultants, subcontractors and insurers are all naturally keen to see how the Supreme Court responds. The further codification of the law on liquidated damages would be very welcome – let’s wait and see what the justices say.

Hamish Lal is head of construction at Jones Day London