“It’s a stone wall penalty. How the ref didn’t see it beats me…….” so Alan Shearer and Robbie Savage regularly exclaim on Match of the Day.
When will a Liquidated and Ascertained Damages (“LADs) clause be a penalty in a Building Contract? The answer now is whether it is in the “legitimate interests” of the Developer, Employer or Contractor that imposes and sets the level of LADs in the Building Contract. For the first time the courts have decided that only where they are “penal” in nature will they be struck down as a penalty and the question of whether LADs are a genuine pre-estimate of loss is no longer the question the courts should be asked in considering whether the LADs clause can be challenged or not. This is because of the earth shattering Supreme Court decision of Cavendish Square Holdings -v- Talal El Makdessi and Parking Eye -v- Beavis [2015] UKSC67 that LADs clauses in Building Contracts cannot be challenged on the grounds that they are not a genuine pre-estimate of loss. They can only be challenged if they are regarded by the courts as “penal” and not because they are not a genuine pre-estimate of loss. The long established rule that unless LADs are a genuine pre-estimate of loss they will be an unenforceable penalty clause has been turned on its head by this decision and has created uncertainty over what is a valid LADs clause in a building contract.
Agreeing the loss in advance
It remains the case that the LADs award is not left to the eagle eye of a referee but they are instead pre-agreed before the contract is signed, and it is still standard practice for the parties to agree the level of LADs, which are often capped at a maximum level. However, the Supreme Court ruled that it is contrary to freedom of contract for the courts to impose on contracting parties that they must set LADs as a genuine pre-estimate of loss.
Instead the Supreme Court in the Cavendish decision has said that “The real question whether a contractual provision is challenged as a penalty is whether it is penal and not whether it is a pre-estimate of loss……”. The court went on to say that instead of considering whether the LADs clause is a genuine pre-estimate of loss or not, the courts will be required to decide whether it is out of all proportion to a legitimate interest (of the developer, employer or main contractor) enforcing it.
The underlying principle of the agreement in Building Contracts has always been that the Contractor would pay the Employer a specified sum regardless of whether actual loss may or may not have suffered by the Employer by reason of delay in completion of the works. In Building Contracts there is only one circumstance when LADs will be paid, namely the failure to complete by the due date or the extended due date for completion. Normally the sum payable is stated to be a fixed amount per day, per week or per month.
Up until the Supreme Court decision of Cavendish it has been for the courts to decide whether the stipulated sum was truly liquidated damages that should be paid in the event of delay or was it really a penalty that should not be paid? The leading case on the approach the courts formerly took to determine what constituted genuine liquidated damages was Dunlop Pneumatic Tyre Company -v- New Garage and Motor Company [1915] AC 79 86. The fact that the parties had labelled a clause “liquidated damages” was not conclusive and the essence of liquidated damages was that they were a genuine pre-estimate of loss. The courts would before the Cavendish decision have found that a clause described as a LADs clause was a penalty where the sum stipulated was greater than the greatest loss that could conceivably be proved by the Developer, Main Contractor or Employer.
When would the courts strike down a LADs clause?
Before the Cavendish decision the courts had been repeatedly asked to rule on whether the level of LAD’s was a penalty or not and they repeatedly came to the view they will not interfere with an agreement reached by the parties on the level of damages unless upon close examination they are found to be in no sense a genuine pre-estimate of loss.
In the Technology and Construction judgment of Alfred McAlpine Capital Projects Limited -v- Tilebox Limited [2005]EWHC 281 dealt with the question of when will an LAD’s clause be interpreted as a penalty clause? The general principle was that the LADs had to be a genuine pre-estimate of loss and if it was not then it would be penalty clause and would therefore be unenforceable. However, in this case the court decided there had to be a substantial discrepancy between the level of damages stipulated in the contract as LADs and the actual level of damages that were likely to be suffered before the courts would say that the agreed pre-estimate was unreasonable.
Mr Justice Jackson said “…. In my view, a pre-estimate of damages does not have to be right in order to be reasonable…………….There must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered before it can be said that the agreed pre-estimate is unreasonable”. The Judge said that that the courts are predisposed to uphold contractual terms which fix the level of damages for breach. “This pre-disposition is even stronger in the case of commercial contracts freely entered into between parties of comparable bargaining power”.
The court said if the question of LADs was the subject of specific debate between the parties to the contract before the contract is executed and LADs was considered not only by the parties but also by their legal advisors then the court would find that the agreed liquidated damages was reasonable.
In this case the LADs were £45,000 per week. The Judge said that “The figure was at or slightly above the top range of possible weekly losses flowing from the delay. Whether one takes the top of the range or the middle of the range of possible future losses as the yardstick, it seems to me to me that the gap between that yardstick and £45,000 was not nearly wide enough to want characterising this clause as a penalty.”
In another case, that of Steria v Sigma Wireless Communications Ltd [2008] B.L.R 79 the TCC decided that great caution had to be exercised before a clause in a commercial contract was struck down as a penalty. If the contract was freely entered into by substantial and experienced companies in the knowledge of the difficulties that could arise from delays in performance the court would not interfere with what had been agreed. On the facts of this case the court decided that there was no substantial discrepancy between the liquidated damages provisions of the sub-contract and the level of damages likely to be suffered by the Main Contractor.
Therefore, before the Cavendish decision the answer to the question of when penalties would be awarded in Building Contracts was that courts would not strike down LADs clauses unless there was an extreme discrepancy between the amount of LADs and the amount of damages likely to be suffered, and if there is evidence that they level of LADs was discussed and agreed before the contract was entered into. The lesson for Developers, Contractors and Employers was that if LADs had been agreed in debate beforehand, and even more so if lawyers were involved, they would not be able to ask the courts to conduct the after the event armchair inquest typified by Shearer and Savage unless it is a “blatant penalty”, that no-one could fail to see as completely outrageous.
“Out of all proportion to legitimate business interests” – the new test
The Supreme Court in Cavendish have now ruled that the test of whether a LADs clause is legitimate or not in a building contract is as follows: -
“a so called liquidated damages clause for delay to completion is an (unenforceable) penalty if it imposes a number (£X/day) on the contractor that is out of all proportion to any legitimate interest of the employer/owner/developer in achieving the target completion date”.
The concern for contractors is that this will lead to the employer asserting any “legitimate interest” and to set an arbitrary sum. This test draws heavily on the concept of “commercial justification” and the uncertainty of what this means will lead to disputes about whether the LADs clause is a reflection of a “legitimate interest” or not. The lesson for Contractors and Sub-Contractors faced with a demand by the Employer or Main Contractor to agree to an onerous and excessive LADs clause is that they should keep a record of discussions about “legitimate interests” when agreeing LADs to avoid future disputes. There is no doubt though that the Cavendish decision will inflate the amount of LADs in the name of “legitimate business interests” and Contractors will cry foul that they are in truth “extravagant”, much like the dive of the striker on Match of the Day that “wins” or “claims” a penalty when none is justified.
Anthony Philpott
26 July 2016
“It’s a stone wall penalty. How the ref didn’t see it beats me…….” so Alan Shearer and Robbie Savage regularly exclaim on Match of the Day.
When will a Liquidated and Ascertained Damages (“LADs) clause be a penalty in a Building Contract? The answer now is whether it is in the “legitimate interests” of the Developer, Employer or Contractor that imposes and sets the level of LADs in the Building Contract. For the first time the courts have decided that only where they are “penal” in nature will they be struck down as a penalty and the question of whether LADs are a genuine pre-estimate of loss is no longer the question the courts should be asked in considering whether the LADs clause can be challenged or not. This is because of the earth shattering Supreme Court decision of Cavendish Square Holdings -v- Talal El Makdessi and Parking Eye -v- Beavis [2015] UKSC67 that LADs clauses in Building Contracts cannot be challenged on the grounds that they are not a genuine pre-estimate of loss. They can only be challenged if they are regarded by the courts as “penal” and not because they are not a genuine pre-estimate of loss. The long established rule that unless LADs are a genuine pre-estimate of loss they will be an unenforceable penalty clause has been turned on its head by this decision and has created uncertainty over what is a valid LADs clause in a building contract.
Agreeing the loss in advance
It remains the case that the LADs award is not left to the eagle eye of a referee but they are instead pre-agreed before the contract is signed, and it is still standard practice for the parties to agree the level of LADs, which are often capped at a maximum level. However, the Supreme Court ruled that it is contrary to freedom of contract for the courts to impose on contracting parties that they must set LADs as a genuine pre-estimate of loss.
Instead the Supreme Court in the Cavendish decision has said that “The real question whether a contractual provision is challenged as a penalty is whether it is penal and not whether it is a pre-estimate of loss……”. The court went on to say that instead of considering whether the LADs clause is a genuine pre-estimate of loss or not, the courts will be required to decide whether it is out of all proportion to a legitimate interest (of the developer, employer or main contractor) enforcing it.
The underlying principle of the agreement in Building Contracts has always been that the Contractor would pay the Employer a specified sum regardless of whether actual loss may or may not have suffered by the Employer by reason of delay in completion of the works. In Building Contracts there is only one circumstance when LADs will be paid, namely the failure to complete by the due date or the extended due date for completion. Normally the sum payable is stated to be a fixed amount per day, per week or per month.
Up until the Supreme Court decision of Cavendish it has been for the courts to decide whether the stipulated sum was truly liquidated damages that should be paid in the event of delay or was it really a penalty that should not be paid? The leading case on the approach the courts formerly took to determine what constituted genuine liquidated damages was Dunlop Pneumatic Tyre Company -v- New Garage and Motor Company [1915] AC 79 86. The fact that the parties had labelled a clause “liquidated damages” was not conclusive and the essence of liquidated damages was that they were a genuine pre-estimate of loss. The courts would before the Cavendish decision have found that a clause described as a LADs clause was a penalty where the sum stipulated was greater than the greatest loss that could conceivably be proved by the Developer, Main Contractor or Employer.
When would the courts strike down a LADs clause?
Before the Cavendish decision the courts had been repeatedly asked to rule on whether the level of LAD’s was a penalty or not and they repeatedly came to the view they will not interfere with an agreement reached by the parties on the level of damages unless upon close examination they are found to be in no sense a genuine pre-estimate of loss.
In the Technology and Construction judgment of Alfred McAlpine Capital Projects Limited -v- Tilebox Limited [2005]EWHC 281 dealt with the question of when will an LAD’s clause be interpreted as a penalty clause? The general principle was that the LADs had to be a genuine pre-estimate of loss and if it was not then it would be penalty clause and would therefore be unenforceable. However, in this case the court decided there had to be a substantial discrepancy between the level of damages stipulated in the contract as LADs and the actual level of damages that were likely to be suffered before the courts would say that the agreed pre-estimate was unreasonable.
Mr Justice Jackson said “…. In my view, a pre-estimate of damages does not have to be right in order to be reasonable…………….There must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered before it can be said that the agreed pre-estimate is unreasonable”. The Judge said that that the courts are predisposed to uphold contractual terms which fix the level of damages for breach. “This pre-disposition is even stronger in the case of commercial contracts freely entered into between parties of comparable bargaining power”.
The court said if the question of LADs was the subject of specific debate between the parties to the contract before the contract is executed and LADs was considered not only by the parties but also by their legal advisors then the court would find that the agreed liquidated damages was reasonable.
In this case the LADs were £45,000 per week. The Judge said that “The figure was at or slightly above the top range of possible weekly losses flowing from the delay. Whether one takes the top of the range or the middle of the range of possible future losses as the yardstick, it seems to me to me that the gap between that yardstick and £45,000 was not nearly wide enough to want characterising this clause as a penalty.”
In another case, that of Steria v Sigma Wireless Communications Ltd [2008] B.L.R 79 the TCC decided that great caution had to be exercised before a clause in a commercial contract was struck down as a penalty. If the contract was freely entered into by substantial and experienced companies in the knowledge of the difficulties that could arise from delays in performance the court would not interfere with what had been agreed. On the facts of this case the court decided that there was no substantial discrepancy between the liquidated damages provisions of the sub-contract and the level of damages likely to be suffered by the Main Contractor.
Therefore, before the Cavendish decision the answer to the question of when penalties would be awarded in Building Contracts was that courts would not strike down LADs clauses unless there was an extreme discrepancy between the amount of LADs and the amount of damages likely to be suffered, and if there is evidence that they level of LADs was discussed and agreed before the contract was entered into. The lesson for Developers, Contractors and Employers was that if LADs had been agreed in debate beforehand, and even more so if lawyers were involved, they would not be able to ask the courts to conduct the after the event armchair inquest typified by Shearer and Savage unless it is a “blatant penalty”, that no-one could fail to see as completely outrageous.
“Out of all proportion to legitimate business interests” – the new test
The Supreme Court in Cavendish have now ruled that the test of whether a LADs clause is legitimate or not in a building contract is as follows: -
“a so called liquidated damages clause for delay to completion is an (unenforceable) penalty if it imposes a number (£X/day) on the contractor that is out of all proportion to any legitimate interest of the employer/owner/developer in achieving the target completion date”.
The concern for contractors is that this will lead to the employer asserting any “legitimate interest” and to set an arbitrary sum. This test draws heavily on the concept of “commercial justification” and the uncertainty of what this means will lead to disputes about whether the LADs clause is a reflection of a “legitimate interest” or not. The lesson for Contractors and Sub-Contractors faced with a demand by the Employer or Main Contractor to agree to an onerous and excessive LADs clause is that they should keep a record of discussions about “legitimate interests” when agreeing LADs to avoid future disputes. There is no doubt though that the Cavendish decision will inflate the amount of LADs in the name of “legitimate business interests” and Contractors will cry foul that they are in truth “extravagant”, much like the dive of the striker on Match of the Day that “wins” or “claims” a penalty when none is justified.
Anthony Philpott
26 July 2016
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