REUTERS | Issei Kato

Makdessi made simple, but will it have any impact on the construction industry?

There was a great deal of furore leading up to the Supreme Court’s judgment in Cavendish Square Holding BV v Talal El Makdessi and Parking Eye Ltd v Beavis, and how the legal landscape might change in distinguishing valid liquidated damages clauses from penalties. Therefore, it was with baited breath that I visited the Supreme Court’s website as soon as the judgment was published. However, I have to admit that it didn’t provide the clarity I had hoped for, and my initial reaction was to question how this might benefit contracting parties, and the construction industry at large.

There has been much written about the case and last week I had the pleasure of attending the SCL talk at the National Liberal Club, London to hear Mathias Cheung, a pupil at Atkin Chambers, present his SCL Hudson Prize winning paper. I have to say that the talk was enlightening, and in some respects justified my initial reaction on reading the case (I must confess I haven’t read all 123 pages of the judgment). Those keen-eyed SCL members will have noted that Mathias’s excellent paper has now also been published.

Pre-Makdessi

You will all be familiar with the test from Dunlop Pneumatic Tyre Co v New Garage Motor Co Ltd for distinguishing between a liquidated damages clause and a penalty. In particular, Lord Dunedin said that an effective liquidated damages clause is a genuine pre-estimate of loss, whereas a sum will be penalty if it is:

“…extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.”

This basically boils down to the genuine pre-estimate of loss test, which was applied by lawyers for 100 years and, to my mind, was relatively straightforward.

Over the years I have assisted a number of clients determine what their genuine losses might be in the event of critical delays in order to set a reasonable level of liquidated damages, and there is some certainty in the test. For example, if a tenant is required to move out of its office as a result of refurbishment works it is relatively straight forward to calculate the weekly cost of alternative accommodation, as well as other costs such as maintaining the professional team for a longer period, increased off-site storage costs, and so on. Indeed, as Mathias rightly notes, the doctrine of penalties hasn’t been particularly problematic for the construction industry, and there are very few reported cases that have resulted in a finding of a penalty clause. That said, the doctrine has certainly been subject to criticism, not least because it is contrary to the principle of freedom of contract.

Post-Makdessi

The Supreme Court has now substituted the Dunlop test for what it says is the correct test, namely:

“The true test is whether the impugned provision is a secondary provision 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.”

In terms of the first part of this test, the Supreme Court clarified that the doctrine of penalties only applies to secondary obligations arising out of breaches of contract. In construction, that means (for example) provisions allowing damages in the event of delay to the completion of the works.

In terms of the second part of the test, Hamish Lal put this in “construction speak” in his Building article soon after the Supreme Court handed-down its judgment:

“…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.”

As Mathias points out, the new test is potentially uncertain compared to the genuine pre-estimate of loss test. For example, we may see an increased number of disputes about what a genuine legitimate interest of the innocent party might be, and when the detriment on the contract-breaker is out of all proportion to that legitimate interest.

Will it have any impact on the construction industry?

It is important to note that the Supreme Court pointed out that in the case of a straightforward liquidated damages clause (such as may be found in most building contracts) the innocent party’s legitimate interest will rarely extend beyond compensation for the breach. Therefore, the Supreme Court expects that Lord Dunedin’s four tests will usually be perfectly adequate to determine the validity of a straightforward liquidated damages clause. Going back to my office block example above, the method of determining liquidated damages will probably remain unchanged.

However, there are many situations where compensation for the breach is not the only legitimate interest the innocent party may have in the performance of the defaulter’s primary obligations. For example, take a residential block of flats that are fully scaffolded and undergoing external decoration. If the contractor is in delay, the owners of the flats are unlikely to incur significant losses, but they might have other legitimate interests in the contractor performing its obligations. These may include the removal of the scaffolding to allow more daylight into the flats,  security reasons or so that the building is more attractive for the flats to be sold. It is these other legitimate interests that the Supreme Court confirmed can be taken into account, and this is what happened in ParkingEye Ltd v Beavis.

ParkingEye Ltd v Beavis

ParkingEye had agreed with a retail park’s owner that it would manage the car park. ParkingEye displayed numerous signs stating that a failure to comply with a two-hour time limit would result in a penalty charge of £85. Mr Beavis overstayed the two hours and refused to pay the £85 ParkingEye demanded as he contended, among other things, that it was an unenforceable penalty.

The Supreme Court decided that both ParkingEye and the landowner had a legitimate interest in charging overstaying motorists, which extended beyond the recovery of any loss:

  • The landowner’s interest  was the provision and efficient management of customer parking for the retail outlets.
  • ParkingEye’s interest was in the income from the charge, which met the running costs of a legitimate scheme plus a profit margin.

The Supreme Court also said that the charge was neither extravagant nor unconscionable, having regard to practice around the country, and taking into account the use of this particular car park and the clear wording of the notices.

Legitimate interests in construction contracts

Mathias considers that taking such legitimate interests into account in construction contracts could result in a shift in contractual risk allocation, inflating sums of liquidated damages, and that this could result in economic inefficiencies. For example, he considers that it could lead to an increase in tender prices as contractors account for the increased risk associated with inflated amounts of liquidated damages.

Creative drafting of primary obligations

It is also worth going back to the point that the doctrine only applies to secondary obligations arising out of breaches of contract, and not primary obligations.

In Makdessi, the Supreme Court decided that the penalty rule was not engaged because the clauses in question were primary not secondary obligations. As Hamish Lal said in his Building article, we could see an increase in contract drafters providing for the contract sum to be reduced if a contractor fails to achieve certain key performance indicators:

“Such drafters would seek to argue that the adjustment of the contract sum in accordance with KPIs is all part of the primary obligation relating to the contract sum and thus nothing to do with the law on penalties relying on the statement that ‘it is not a proper function of the penalty rule to empower the courts to review the fairness of the parties’ primary obligations, such as the consideration promised for a given standard of performance’.”

In my view, Makdessi is likely to have an impact on the construction industry, but we will have to wait and see what that impact is, and whether it is positive or negative.

And finally

You might be interested to know that the second prize in the SCL Hudson Prize competition went to Rachel Gwilliam for her paper on recovering adjudication costs under the Late Payment of Commercial Debts (Interest) Act 1998. Rachel will be presenting her paper to the SCL at the National Liberal Club in July but you will need to get there early as, just like Mathias’s talk, it is likely to prove very popular.

MCMS Ltd Jonathan Cope

Leave a Reply

Your email address will not be published. Required fields are marked *