For many years, the distinction between LDs and penalties has not been so clear cut. Traditionally the distinction was assumed to be based on whether the rate of damages was a “genuine pre-estimate of loss”. However, recent case law has sought to challenge this traditional distinction and introduce other factors for consideration.
In the case of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis  UKSC 67, the test for determining a LD clause was considered by the Supreme Court and almost a century after the test was first laid down, a welcome degree of clarity was provided in this area.
General overview of what is an LD/LAD
Liquidated damages (LDs) also known as liquidated and ascertained damages (LADs) are a well established provision used within construction contracts. Typically parties to a construction contract will include LDs to avoid the often complex and time consuming process of determining general damages in the event of a dispute. LDs are a mechanism by which the parties agree a pre-determined level of damages of which the employer will be entitled to in the event of certain specified breaches of the contract.
Most commonly, LDs are drafted to account for a delay related breach and in process contracts in relation to performance guarantees. Such clauses will provide that if the contractor fails to complete the works by the contract completion date (subject to the operation of any extension of time provisions), the employer will be entitled to LDs at a daily fixed rate until the contractor completes the works. This provides certainty for both parties by knowing at the outset the exact financial liability of the contractor if it fails to complete on time.
As a general rule, LDs are enforceable provided that they do not breach the “penalty rule”.
As set out by Lord Dunlop in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 there are four tests to determine whether a clause is an unenforceable penalty:
- The provision would be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach;
- It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid;
- There is a presumption (but no more) that is a penalty when a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events;
- The sum stipulated should be a genuine pre-estimate of damage.
For over a century practitioners used Lord Dunlop’s traditional test to determine whether LDs constituted a penalty. This depended on whether the rate of damages agreed between the parties was a genuine pre-estimate of loss: “The essence of liquidated damages is a genuine covenanted pre-estimate of damage.”
However, in the recent case of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis  UKSC 67, the Supreme Court has restated the test and changed the principal basis on whether a clause will be deemed to be a penalty.
Facts of Cavendish
Mr Makdessi founded a group of companies which had become the largest advertising and marketing communications group in the Middle East. Mr Makdessi and his business partner Mr Ghossoub were the majority shareholders of the group's holding company. In 2008, the duo entered into a share and purchase agreement (SPA) to sell the holding company and as a result Cavendish became the majority shareholder.
Clause 11.2 of the SPA contained restrictive covenants to be adhered to by both Mr Makdessi and Mr Ghossoub. The restrictive covenants included non-competition provisions. Clause 5 of the SPA contained provisions related to “Default”. In particular clause 5.1 provided that if a seller becomes a defaulting shareholder (defined as including ‘a seller who is in breach of clause 11.2) they will not be entitled to receive the interim and or final payments (which made up the total consideration under the SPA); and clause 5.6 provided that if such a seller became a defaulting shareholder, Cavendish may require them to sell to Cavendish all of their shares.
By December 2010, Cavendish found out about certain activities of Mr Makdessi and considered him to be in breach of clause 11.2. As a result, they invoked clauses 5.1 and 5.6. Mr Makdessi admitted he was in breach however he argued that clauses 5.1 and 5.6 were unenforceable penalties under the penalty rule.
The Supreme Court considered the validity of clauses 5.1 and 5.6 and in doing so reset the test for what is now considered to be a penalty clause.
Lords Neuberger and Sumpton held that “the true test is whether the impugned provision 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. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.”
In addition, they considered that:
- If a clause is not a genuine pre-estimate of loss this does not necessarily mean that it is a penal clause, rather the real question to ask is simply whether the clause is penal in nature; and
- Determining what is penal will partly depend on whether it is unconscionable or extravagant
What did this mean for Cavendish and Mr Makdessi?
The Supreme Court considered clauses 5.1 and 5.6 to be valid and enforceable. In reaching this conclusion their Lordships considered the commercial background to the SPA including the equal bargaining positions of the parties; both parties having had the benefit of professional advice and that a significant proportion of the purchase price paid for the shares represented the value of goodwill in the business. In light of this background, they held that the clauses were in fact primary obligations of Mr Makdessi and therefore were not caught by the penalty rule.
The Supreme Court judgement has been welcomed by many for adding clarification in this area of law.
For construction practitioners and those working within the construction industry, this judgment provides helpful guidance with the drafting of LD clauses.
When negotiating such clauses and determining the enforceability of such clauses it is now helpful to bear the following points in mind:
- LD clauses are a secondary obligation and therefore will still be caught by the new penalty rule.
- The court has shown reluctance to interfere with commercial agreements and the freedom of parties to agree their own terms. Therefore when negotiating and drafting the LD clause it is in both parties interests to ensure that the terms are carefully considered because it is likely that they will be held accountable to such terms in a potential dispute.
- Where possible, it is still important to determine the rate of damages under such a clause as genuine pre-estimates of loss. Although this is now less of a fundamental factor for determining the penal nature of a clause, it will still be a relevant factor taken into consideration. This is potentially all the more relevant concerning simple LD clauses whereby other more complex factors are not necessarily present.
- It is worth considering whether the sanction/ rate of damages is in line with an industry norm or standard. This will avoid the potential for it to be interpreted as “unconscionable” or “extravagant”.
Author: Andrew SymmsThis information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.