Liquidated damages: Time for a penalty shoot-out?

Liquidated damages are often used in construction contracts. Put simply, they are a genuine pre-estimate of loss agreed between the parties. Put even more simply, if the contractor misses his completion date, the employer will charge damages at the agreed rate for every week or part of a week the date is missed. The idea is that there will be no need for an expensive argument over proof of or entitlement to damages; no need to instruct expensive lawyers and cost consultants to work out how much you’re owed if your contractor is late: you’ve already agreed the amount before the contract is signed. Liquidated damages are in theory a simple, cost effective and efficient contractual tool.

If only things were so simple. As you would expect, the commercial consequences of paying substantial damages encourages challenges to be made to the enforceability of such clauses. As a matter of English law, the courts have made clear that in this context penalty clauses will not be enforced. Case law has built up around the idea that liquidated damages cannot be a penalty and should represent at “genuine pre-estimate of loss”. If they are found to be a penalty then they are likely to be struck out by the courts. Extravagant liquidated damages of thousands of pounds per day are likely to arouse suspicion if at the time the contract was negotiated the employer’s estimated losses were only a few hundred pounds per week. We have been told that liquidated damages should be a carrot (where each party can see his potential losses in advance and thereby understand the risk) rather than a stick (where a punitive figure seeks to terrify a contractor into running the project on time).

Recent case law suggests that the courts are moving towards assessing liquidated damages as being ‘commercially justified’ rather than a pre-estimate of loss

This has led to a focus on genuine pre-estimates and avoiding what appeared to be punitive deterrents. However, recent case law suggests that the courts are moving towards assessing liquidated damages as being “commercially justified” rather than a pre-estimate of loss. The courts seem to want to reflect what has been agreed in the market by well-advised parties. The most important recent case on liquidated damages has just gone before the Supreme Court. Although it isn’t a construction case, it may have a profound effect on our industry.

The case of El Makdessi concerns a form of liquidated damages clause that was held, by the Court of Appeal, to be a penalty. The case involved Mr Makdessi who resigned from a Middle Eastern advertising agency he helped establish and was forced to sell his shares at a price which excluded goodwill (and was therefore significantly discounted). This should be contrasted with another recent Court of Appeal case (Parkingeye Limited) where the court held that an £85 charge for overstaying a parking restriction in a private car park by about an hour was not deemed to be a penalty.

Commercial justification, public policy and a contractual deterrent are all balancing concerns the Supreme Court will have to take into consideration in their judgment in El Makdessi. On this basis we are hoping the court will clear up the matter of liquidated damages once and for all and case law may soon provide revised guidelines as to when liquidated damages will be deemed to be an un-enforceable penalty.

Until then, stating in your contract that the rate of liquidated damages is a genuine pre-estimate of loss is not going to save your provision from being struck out. You may wish to give serious consideration to commercial justifications for the figure included and expressly state what they are.

Another suggestion could be to reverse the liquidated damages provisions in your contract and make the amount a clear ‘carrot’ by providing for ‘bonus’ or incentive payments to be paid if a completion date is met (rather than damages if they are not met). For the time being at least, we should tread carefully when including liquidated damages in contracts.

Chris Paul is a partner in the projects and construction team at law firm Trowers & Hamlins. Stephanie Canham is away