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When does an agreed liquidated damages clause go too far and become a penalty?

20 July 2015 #Construction


Liquidated damages clauses are commonly used in construction contracts as a solution to deal with specified breaches. However, the courts have refused to enforce liquidated damages which are deemed to be a penalty. This article considers what scope parties have for arguing that the courts should intervene and the liquidated damages clause be ruled ineffective.

The rule against penalties

Contracting parties are generally free to agree to whatever terms they like. Liquidated damages clauses are commonly used in construction contracts to make the recovery of damages easier and quicker. Liquidated damages remove the need for the employer to prove its actual loss and to mitigate the loss covered by the liquidated damages clause. From a contractor's perspective, liquidated damages act as a limit on its liability for the specified breach, such as a failure to complete the works on time or a failure to meet specified performance targets.

To be upheld by the courts, a liquidated damages clause must be a genuine pre-estimate of any loss likely to be sustained. The liquidated damages figure should therefore reflect the loss that the employer would suffer in the event of a specified breach occurring.

The parties rights to stipulate liquidated damages is subject to the rule against penalties, which will apply regardless of whether the contract was negotiated by parties with equal bargaining power and by experienced lawyers. Under English law, if a clause amounts to a penalty, it is likely that it will be unenforceable.

A liquidated damages clause will be classed as a penalty if instead of being a genuine pre-estimate of the employer’s loss, the level of liquidated damages acts as a deterrent to prevent the contractor from breaching the contract.

The approach of the courts

Recently, the courts have changed their approach in relation to liquidated damages and the laws of penalties. Recent case law indicates that providing there was a commercial justification for the liquidated damages clause and the clause does not act as a deterrent to prevent a party from breaching the contract, a liquidated damages clause which does not represent a genuine pre-estimate of the loss suffered may still be enforced.

To determine whether a clause is penal, the Court of Appeal in Talal El Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 1539 asked the following questions; (1) whether the liquidated damages clause was a genuine pre-estimate of loss; and (2) whether there was a commercial justification for the liquidated damages clause (even if the clause is a penalty).

As highlighted by the Court of Appeal in Talal El Makdessi v Cavendish Square Holdings BV; "everything depends on the circumstances of the individual case". Accordingly, whether the clause serves a justifiable commercial or economic function (question number 2) will turn on the specific facts of each case.

In Talal El Makdessi v Cavendish Square Holdings BV, the Court of Appeal held the liquidated damages provisions were not a genuine pre-estimate of loss and there was also no commercial justification for the provision as the sum the seller would lose as a result of the specified breaches was disproportionate to the amount of liquidated damages the seller could deduct under the contract. This decision limits the circumstances in which liquidated damages clauses which are not genuine pre-estimates of loss can be held commercially justifiable.

The recent case of Unaoil Ltd v Leighton Offshore Pte Ltd [2014] EWHC 2965 highlights the potential consequences where subsequent contract amendments undermined the appropriateness of a previously agreed liquidated damages provision. Whilst the court considered that the liquidated damages may have been a genuine pre-estimate of loss when the un-amended contract was entered into, at the date of the amendment to the contract the liquidated damages provision was deemed to be “extravagant and unconscionable with a predominant function of deterrence”. As there was no other commercial justification for the provision, the court held that the liquidated damages clause was a penalty and therefore unenforceable. Depending on the factual circumstances, this case demonstrates there may be scope for challenging a liquidated damages clause.

In contrast to the above two cases, the court found that a liquidated damages clause which related to unauthorised changes in personnel under a construction contract was commercially justifiable in the case of Bluewater Energy Services BV v Mercon Steel Structures BV [2014] EWHC 2132. The court held that the level or liquidated damages was not unconscionable or extravagant. This case demonstrates the court’s willingness to adopt a flexible and commercial approach towards interpreting liquidated damages clauses rather than following the strict principle of a genuine pre-estimate of loss.

What to consider when drafting liquidated damages clauses

  • To remain valid and enforceable, liquidated damages clauses should still be a genuine pre-estimate of the employers loss.
  • When drafting a contract or contemplating a variation to a liquidated damages provision, consider the appropriateness of the liquidated damages clause.
  • Commercially, when calculating a liquidated damages clause (and especially if the level of liquidated damages is high, but there is commercial justification for this), employers should keep detailed records of how the liquidated damages were arrived at. To ensure such information can be taken into consideration later on, the information should be included in the contract.
Clarkslegal, specialist Construction lawyers in London, Reading and throughout the Thames Valley.
For further information about this or any other Construction matter please contact Clarkslegal's construction team by email at constructionsector@clarkslegal.com by telephone 020 7539 8000 (London office), 0118 958 5321 (Reading office) or by completing the form on this page.

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Victoria  Kempthorne

Victoria Kempthorne
Senior Solicitor

E: vkempthorne@clarkslegal.com
T: 0207 539 8062
M: 0791 783 1789

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