REUTERS | Alex Domanski

Penalty clauses: does the punishment fit the crime?

I recently advised on the question of whether a liquidated damages clause was a penalty. My attention was drawn to the recent case of Cavendish Square Holdings BV and another v El Makdessi. You may not have come across this judgment, as it is not a construction case, and does not concern liquidated damages. Rather, the question of whether a clause was a penalty arose in the context of a restraint of trade clause. Nevertheless, the court’s decision provides an important reminder to those negotiating liquidated damages clauses in construction contracts.

Freedom to contract

Wherever possible, the English courts try to uphold the parties’ freedom to contract. For that reason, they are loathe to strike down any freely negotiated clauses, and this includes liquidated damages clauses. That said, in the Cavendish Square Holdings case, the court held that the clause could allow the claimant to obtain double recovery. However, rather than setting aside the clause, the court ordered the claimant to give credit for the sum that it would have recovered twice. Those negotiating liquidated damages clauses should be aware that such clauses are set aside extremely rarely. The only way for a contractor to get out of a liquidated damages clause it has freely signed up to, is to show that such a clause is a penalty.

What makes a clause a penalty?

In the past, it was necessary to demonstrate that the amount payable under the clause was not a genuine pre-estimate of loss and this formed the basis of our advice to clients both at the drafting stage and when looking to the enforcement of such provisions.

Recent cases though seem to have suggested a movement away from that test to one that looks more towards whether or not the clause in question is commercially justifiable. One such case is Azimut-Benetti Spa (Benetti Division) v Healey, which concerned liquidated damages in a shipbuilding contract.

That this is now the approach when deciding the penalty is confirmed in the latest case. According to Cavendish Square Holdings, the law has moved on from a simple dichotomy between liquidated damages clauses on the one hand and penalty clauses on the other. In order to show that a clause is a penalty, it is no longer necessary to show that there was no genuine pre-estimate of loss.

A new test?

Under the revised test one must demonstrate that:

  • There is no commercial justification for inclusion of the clause.
  • The clause is extravagant or oppressive.
  • The purpose of the clause is to deter breach.
  • The provision was not negotiated on a level playing field (if relevant).

What implications does this have for those negotiating construction contracts?

According to the above test, a clause providing for a very high level of liquidated damages may not be a penalty, as long as there is a commercial justification for including it. So is it now ever relevant to demonstrate that the liquidated damages are based on a genuine pre-estimate of loss? In my view it remains the simplest, most effective way of showing that liquidated damages are not a penalty. If your liquidated damages are calculated to reflect your genuine expectations of your losses, this demonstrates that there is a commercial justification for the clause, and that it is neither extravagant nor oppressive. Our advice remains that wherever possible, you should calculate a genuine pre-estimate of the likely loss the clause is aimed at, record details of your calculation, pass them to your opposite number, and keep copies.

This “modern approach”, where the courts are willing to look to commercial justification, may lead to employers seeking to impose significantly higher liquidated damages. In the Cavendish Square Holdings case the commercial justification was the adjustment of consideration between the parties based on substantial loss of goodwill. In the construction context, employers looking to incorporate liquidated damages at a figure that cannot necessarily be referenced to a pre-estimate of their likely losses will need to think carefully about what the “commercial justification” for the provision really is.

The movement in the court’s approach to penalty clauses and what this means for liquidated damages provisions in construction contracts, makes matters less certain for parties trying to negotiate these important clauses. Liquidated damages clauses are used because of the certainty they bring to both sides, but parties should consider whether there are circumstances in which general damages offer a more appropriate remedy than liquidated damages in any event. It is important to identify at the outset which categories of loss the liquidated damages are intended to cover, as this helps to avoid later arguments about attempting double recovery and also is less likely to result in parties inserting an liquidated damages clause into the contract when general damages may be a better solution.

4 thoughts on “Penalty clauses: does the punishment fit the crime?

  1. Thank you for your guidance on this. Having thought through the practical consequences of this I am slightly concerned with point one of the ‘new test’. In the event from a contractors point of view there is no commercial jusification for inclusion of the clause, does this result in damages being at large?

    Acting as a subcontractor you would by implication accept the terms of the main contract regarding LDs and how would you then challenge the level of LDs in the main contract?

    Many Thanks

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