Are Liquidated Damages ever a penalty?

Liquidated Damages clauses in contracts are still a major source of disputes between parties to construction contracts. This article looks at the background and more recent developments to assess the courts’ attitude to such clauses and considers when they are likely to be viewed as a penalty.

1st October 2014

Liquidated Damages clauses in contracts are still a major source of disputes between parties to construction contracts. This article looks at the background and more recent developments to assess the courts’ attitude to such clauses and considers when they are likely to be viewed as a penalty.

Background to Liquidated Damages

The key authority on liquidated damages remains the speech of Lord Dunedin in Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited [1915] AC 79 where he set out a series of propositions on the distinction between liquidated damages and penalties. These propositions have been consistently referred to and relied upon by the courts since then and can be summarised as follows:

The court must seek to determine whether the sum in question is in truth a penalty and the use of words like “liquidated damages” and “penalty” in the contract is largely irrelevant.

A penalty is a sum designed to threaten the offending party to prevent breach. Liquidated damages are a genuine pre-estimate of the loss and damage caused by a breach.

Assessing whether a sum is a penalty or a genuine pre-estimate of the loss must be judged as at the time of the making of the contract, not at the time of the breach.

An extravagant and unconscionable sum is a likely pointer to it being a penalty. But the difficulty or impossibility of making a precise pre-estimate is no obstacle to that pre-estimate being considered as acceptable liquidated damages.

These matters were revisited in the more recent case of Alfred McAlpine Capital Projects Limited v Tilebox Limited [2005] BLR 271 (TCC) where Mr Justice Jackson added a number of additional propositions:

  1. A pre-estimate of loss doesn’t have to be right to be reasonable; there must be a substantial discrepancy between the pre-estimated sum stipulated in the contract and the level of damages likely to be suffered before that pre-estimate will be considered unreasonable.
  2. The genuineness or honesty of the party who makes the pre-estimate is irrelevant as the assessment of the reasonableness of the pre-estimate is an objective one.
  3. The courts are pre-disposed, where possible, to uphold the contractual terms of liquidated damages and that pre-disposition is stronger still in the case of commercial contracts entered into between parties of comparable bargaining power.

Reluctance to Interfere in Commercial Contracts generally

Recent cases in England have underlined the courts’ general reluctance to intervene in commercial contracts to declare a liquidated damages provision a penalty. These cases are likely to be highly persuasive in the Scottish Courts.

The Courts general approach was discussed in Philips v The Attorney General of Hong Kong [1993] 61 BLR 41 where the following statement was affirmed by the Privy Council:

"It is now evident that the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum.  It has no place where there is no oppression."

This general approach was developed in the third proposition of Mr Justice Jackson in the Alfred McAlpine case of 2005 above, reinforcing the courts’ particular reluctance to interfere in commercial contracts between commercial entities with “comparable bargaining power”. Such interference will only be considered where there has been clear oppression of one party.

The “Commercial Justification” Test

The “commercial justification” test was first suggested by the High Court in the case of Lordsvale Finance Plc v Bank of Zambia [1996] QB 752, where Colman J said:-

"There would therefore seem to be no reason in principle why a contractual provision the effect of which was to increase the consideration payable under an executory contract upon the happening of a default should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, provided always that its dominant purpose was not to deter the other party from breach."

The Court of Appeal affirmed the position in the 2013 case of El Makdessi v Cavendish Square Holdings [2013] EWCA Civ 1539 where it was held at paragraph 117 that:-

"For these reasons I am satisfied that the clauses, taken in the context of the Agreement as a whole, are not genuine pre-estimates of loss. On the contrary they are extravagant and unreasonable. That is not necessarily conclusive. A commercial justification may mean that a clause which is not a genuine pre-estimate is not penal."

Taken together, these cases show that the key consideration is now whether the liquidated damages provision is considered oppressive and having the dominant purpose of deterring a breach. Also, even where a provision is not a "genuine pre-estimate" of loss, the provision may yet survive if there is a commercial justification for it. In other words, if you can justify your position commercially, if for example there is a specific commercial rationale for the provision, then a provision which may otherwise have failed as a penalty could still be upheld.

Liquidated Damages for Key Personnel

The recent case of Bluewater Energy Services BV v Mercon Steel Structures BV [2014] EWHC 2132 (TCC) has considered the validity of a liquidated damages clause linked to unauthorised changes in personnel under a construction contract.

The case concerned a sub-contract between Bluewater Energy Services and Mercon Steel Structures as part of a wide ranging dispute. The sub-contract contained a list of Mercon's key personnel and provided that, firstly, Mercon could not change key personnel without Bluewater's prior approval and, secondly, Mercon would pay liquidated damages to Bluewater for each replacement, unless otherwise agreed. The liquidated damages applied to 7 key personnel and ranged from €20,000 to €50,000.

A number of replacements occurred and Bluewater claimed liquidated damages. Mercon argued the liquidated damages clause was a penalty and thus unenforceable. Mercon argued that any actual loss suffered by Bluewater would be minimal and, in comparison, €50,000 was clearly intended to be a penalty to deter breach. However, the court disagreed. It emphasised the court's general reluctance to interfere with an agreed contractual term and noted that the parties had freely negotiated the liquidated damages amount. Although it was impossible to put a precise figure on any loss suffered by Bluewater, the figure had been assessed by people who were experienced in such projects. In the context of the project, the court held €50,000 was not unconscionably extravagant. The court also noted that the difficulty of putting a precise figure on any loss suffered could actually be a factor in favour of the clause being a “genuine pre-estimate” as opposed to a penalty.

Conclusion

So the traditional propositions of Lord Dunedin in Dunlop hold true today, and are a reasonable starting point - if you can justify the level of liquidated damages using those propositions then the courts are extremely unlikely to strike them down. But, if the sum you are stipulating is high, perhaps even extravagant and unreasonable, it may yet survive if there is a particular underlying commercial justification.

The impossibility of determining precisely what loss may be suffered will not prevent liquidated damages from succeeding. In fact, situations where pre-estimating loss is particularly difficult tend to be where stipulating a sum is most beneficial to both parties and which the courts will be most inclined to uphold.

Given that it is increasingly difficult for a party to argue that a sum is a penalty, it is more sensible for commercial parties to discuss and agree a liquidated damages sum. This provides certainty to both sides, allowing contractors to price the liquidated damages and employers to have some certainty as to the outcome in the event of a contractor breach. Provided there is evidence of free negotiation together with an assessment of potential losses and an attempt to value those losses, the courts will be very reluctant to interfere.