A recent ruling holds implications for liquidated damages clauses. Chris Bridges reports.

On 4 November 2015 the UK Supreme Court handed down judgment in the consolidated appeals of Cavendish Square Holding BV v Talal El Makdessi, and ParkingEye Ltd v Beavis. This was the first time in 100 years that the Supreme Court (or the House of Lords before it) had considered the principles underlying penalty clauses. While these are not construction cases, they are of importance to anyone in the construction industry involved with liquidated damages (LADs) clauses.

Most construction contracts contain a LADs clause, setting out the specific amount agreed by the parties at the time of entering into the contract which will fall to be charged in the event of a breach or delay.  Traditionally, to be enforceable, LADs clauses have had to constitute a genuine pre-estimate of loss; if not they amount to a penalty and are struck down (Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd (1915) ). Thus, parties to construction contracts have frequently been advised to undertake a comprehensive assessment of LADs and to keep this on file.

Recently, courts have attempted to move away from the rigid test of either a genuine pre-estimate of loss on the one hand or a penalty on the other and have sought to apply a ‘commercial justification’ test. But how does this all fit together?

In its Cavendish judgment, the Supreme Court has provided welcome clarification, acknowledging that, while Dunlop still applies, its tests are only considerations and may not apply to all cases. In particular, the Court observed that there were unsatisfactory distinctions between:

• a penalty and a genuine pre-estimate of loss; and
• a genuine pre-estimate of loss and a deterrent.

It did not necessarily follow, the Court suggested, that a proper pre-estimate of loss is not a penalty, and vice versa.

Instead, the Court indicated that the proper test was whether “[the] 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.”

On the facts before the Court, where both parties had expert legal advice and equal bargaining power, there was a strong initial presumption that “the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach”.

One of the Lord Justices, Lord Mance, suggested that this boiled down to a two stage test:

• Whether (and if so what) legitimate business interest was served and protected by the clause; and
• If such an interest existed, was the provision “in the circumstances extravagant, exorbitant or unconscionable”.

In both sets of factual circumstances before the court, contractual deterrents were held not to be penalty clauses, and were valid:

• A deduction in purchase price of shares of some US$ 44m was a legitimate deterrent given the importance of non-breach to the deal; and
• An undeniably high parking fine of £85 was a legitimate deterrent given the need to properly manage and allocate town centre parking.

So what does this mean for LADs in construction disputes? While it would be unwise to jump at the opportunity to inflate LADs in future contracts, this decision may lend support to an argument for LADs that go beyond a ‘genuine pre-estimate of loss’, particularly on a project that has inflexible deadlines or extreme consequences of delay, as this may well be considered a legitimate business interest.

To inflate LADs based on this decision alone would be playing with fire. However, it will be interesting to see how this decision is applied in the context of construction disputes over the coming year. Watch this space.

About the author:  Chris Bridges is a trainee solicitor with Thomas Eggar LLP