For the first time in a century, the Supreme Court has recently considered the law of penalties, when handing down its judgments on two cases relating to contractual penalty clauses . In principle, these decisions will be applicable to liquidated damages clauses in construction contracts.
The previous position
Prior to these decisions, the amount of liquidated damages had to represent a genuine pre-estimate of the employer’s loss. A liquidated damages clause would be unenforceable if the level of damages was extravagant, bore no resemblance to the employer’s loss or was intended to deter a breach of contract.
The Supreme Court’s decision
The court decided that the doctrine of penalties should be upheld, but it rejected the ‘genuine pre-estimate‘ test which was established just over one hundred years ago .
Instead, it decided that the true test as to whether a clause constituted an unenforceable penalty was whether or not it imposed a detriment which was “out of all proportion to any legitimate interest of the innocent party”.
The practical effect of the new test is well illustrated by the ParkingEye case. Here, the car park owner set a high charge (£85) for overstays, as it relied on these amounts to keep the business afloat. Whilst this had the indirect effect of punishing the wrongdoer, it was recoverable as it could be backed up by a legitimate business interest (i.e. the charges were needed to keep the business afloat). This points towards quite a significant relaxation of the test – the charge bore no resemblance to ParkingEye’s actual loss (which is probably next to nothing in most circumstances), but the fact that it allowed them to make a small profit meant it was enforceable.
Whether an employer will now be able to claim that it relies on high levels of liquidated damages to stay afloat remains to be seen, but it seems unlikely. What the new test does mean, however, is that when calculating the amount of liquidated damages in a contract, an employer can include considerations such as (1) the knock-on effect of delay on the rest of the project, (2) loss of reputation, or (3) any amounts it might become obliged to pay to its future occupiers as a result of the delay.
Also significant was the fact that the Supreme Court emphasised that where there are two properly advised parties of comparable bargaining power, the presumption is that the parties themselves are the best judges of what is ‘legitimate’.
Points to note
- Commercial interests, such as goodwill, reputational damage, third party interests, and other losses which can be easily quantified will be taken into account in determining the level of liquidated damages which is recoverable.
- There is a strong initial presumption that a clause is not disproportionate if it has been negotiated in a commercial contract between two comparable parties and their respective legal advisors.
- An employer may be obliged to show documentary evidence of the legitimate commercial interest which the liquidated damages relate to.
- If a contractor successfully challenges a liquidated damages clause, the employer remains entitled to general damages in the usual way.
A calculation based upon ‘legitimate commercial interests’ might sound similar to one based upon ‘a genuine pre-estimate of loss’, but in practice, it looks likely to be an easier test for employers to meet. The main difference is that clauses which are, in principle, intended to deter a breach of contract will now be enforceable (this being a legitimate commercial interest of the employer). However, a fine line needs to be drawn between liquidated damages which are intended to deter a breach, which are allowed, and liquidated damages which are intended to punish the contractor, which are not.
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 Cavendish Square Holdings v El Makdessi and ParkingEye Limited v Beavis  UKSC 67
 Dunlop Pneumatic Tyre Company, Limited Appellants; v New Garage and Motor Company, Limited Respondents  AC 79