The Supreme Court recently gave judgment in the joined cases of Cavendish v Makdessi and ParkingEye v Beavis relating to penalty clauses; one relating to the reduction in price by $44 million USD for the sale of a multinational group of PR companies and the other to an £85 parking charge for overstaying the two free hours in a car park. In a lengthy 124 page judgment, the Supreme Court reviewed the basis of the penalty rule – being, in broad terms that contractual penalty clauses for breach of contract are unenforceable. As such clauses are unenforceable, a common defence to a claim for liquidated damages is that the liquidated damages clause amounts to a penalty clause and therefore is unenforceable because it falls foul of the rule.
The main question to be answered in the Cavendish and ParkingEye cases is determining what in law amounts to a ‘penalty clause.’ The (majority of the) Supreme Court reformulated the test to be:
“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.”
While this reformulation may not appear to be in the most accessible terms for the busy project quantity surveyor on the ground, by breaking it down into four main points it becomes more straightforward:
- “secondary obligation”: the clause in question must relate to the consequences for the breach of a party’s primary contractual obligation(s) (i.e. the secondary obligation is to pay liquidated damages for the breach of the primary obligation to complete a project by a specified date).
- “detriment on the contract-breaker”: such a clause needs to impose a detriment which includes the requirement to pay a sum of money (i.e. liquidated damages), the withholding of a payment or the ‘forced’ transfer in property.
- “out of all proportion to any legitimate interest”: the detriment (i.e. liquidated damages) needs to be extravagantly disproportionate to the point where it is simply punishing the defaulting party. In determining what is disproportionate the court will have regard to the legitimate interest being protected by the clause and any such disproportionality will need to be to an “extravagant” or “unconscionable” degree (i.e. are the liquidated damages “extravagant” or “unconscionable” in comparison to any losses that the employer may suffer through late completion). In determining whether it is “extravagant” or “unconscionable” the court may have regard to industry practice for comparable charges (i.e. at what level other employers have set liquidated damages for similar projects).
- “legitimate interest”: in determining whether the detriment is disproportionate the court will look at what interest the party is seeking to protect through the clause (i.e. the employer’s interest in having the project completed on time in order to avoid losses due to lost profits, lost income or rescheduled works).
The ‘old rule’ as set out largely by the House of Lords in 1915 was based upon whether the clause in question represented a “genuine pre-estimate of damage” and if it did, it was enforceable. Whilst the Supreme Court has reformulated the test away from this approach by focusing on a comparison of the detriment suffered to the interests protected; in respect of liquidated damages, it may not have shifted that far. The Supreme Court expects that when dealing with straightforward liquidated damages clauses, that the old approach would usually be perfectly adequate to determine whether such a clause falls foul of the penalty rule. However, despite the weight of this decision (legally as well as physically!), the door is left open for argument as to what the test requires when it comes to complex commercial agreements where the potential penalty clause is less clear cut as the Justices did not all agree on what and how the principles apply.