When do liquidated damages become an irrecoverable penalty?
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How the Courts Decide Whether a Sum is a Penalty or Genuine Pre-Estimate of Loss Makdessi v Cavendish 1 provides a useful summary of the law on interpreting sums in contracts as irrecoverable penalties or deductible liquidated damages After making reference to the key authorities on liquidated damages 2 , Lord Justice Clarke set out the guidelines for determining whether the clause is a genuine pre-estimate: 3 Guidelines i) A sum will be penal if it is extravagant in amount in comparison with the maximum conceivable loss from the breach; ii) A sum payable on the happening or non-happening of a particular event is not to be presumed to be penal simply because the fact that the event does or does not occur is the result of several breaches of varying severity; iii) A sum payable in respect of different breaches of the same stipulation is not to be presumed to be penal because the effect of the breach may vary; iv) The same applies in respect of breaches of different stipulations if the damage likely to arise from those breaches is the same in kind; v) But a presumption may arise if the same sum is applicable to breaches of different stipulations which are different in kind; vi) There is no presumption that a clause is penal because the damages for which it provides may, in certain circumstances, be larger than the actual loss; and vii) Where there is a range of losses and the sum provided for is totally out of proportion to some of them the clause may be penal. He also said that even where the amounts were not genuine pre-estimates of loss, and were extravagant and unreasonable, this was “not necessarily conclusive. A commercial justification may mean that a clause which is not a genuine pre-estimate is not penal.” 4 General Guidance He then stressed that there are limitations on the applicability of these guidelines003A 5 1. The correct interpretation is fact and case dependent 2. Each of the guidelines is a rebuttable presumption 3. The wrong-doer has to prove that the term is penal based on the contract as a whole and the context in which it was made. 4. The court “recognises the utility of liquidated damages clauses and that to hold them to be penal is an interference with freedom of contract. It is, therefore, predisposed to uphold clauses which fix the damages for breach.” 5. “A pre-estimate does not have to be right to be reasonable”. 6. The bargaining power of the parties does not mean the court cannot intervene Purpose of the Amount The court said that “the fact that a payment on breach may not really be a pre-estimate of loss does not mean that it must be penal. If there is a good commercial justification for the provision that may be a ground for deducing that deterrence of breach was not the dominant purpose of the term.” Conclusion The starting point is that the parties have freedom to contract which means they can choose the terms on which they want to do business. You will have an uphill struggle to persuade the courts to allow you to avoid agreed terms.
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An overview of the recent case Makdessi v Cavendish [2013]. In this case the court reviewed agreed damages ie sums set out in a construction contract payable on breach of that contract. Such damages, known as liquidated damages or LADs are often payable for delay on construction projects. This note summarises the judgment of the Court of Appeal. For further information on penalties see www.500words.co.uk/blog. The note was developed by Sarah Fox, author of the 500-Word Contract. The tips and techniques from her 500-Word series of talks, workshops and contract coaching will help you create simple, ethical contracts you can read, use and understand. Contact her by email [email protected] or for more information, visit her website www.500words.co.uk
Transcript of When do liquidated damages become an irrecoverable penalty?
How the Courts Decide Whether a Sum is a Penalty or Genuine Pre-Estimate of Loss
Makdessi v Cavendish1 provides a useful summary of the law on interpreting sums in contracts as
irrecoverable penalties or deductible liquidated damages After making reference to the key authorities on liquidated damages2, Lord Justice Clarke set out the guidelines for determining whether the clause is a genuine pre-estimate:3 Guidelines
i) A sum will be penal if it is extravagant in amount in comparison with the maximum conceivable loss from the breach;
ii) A sum payable on the happening or non-happening of a particular event is not to be presumed to be penal simply because the fact that the event does or does not occur is the result of several breaches of varying severity;
iii) A sum payable in respect of different breaches of the same stipulation is not to be presumed to be penal because the effect of the breach may vary;
iv) The same applies in respect of breaches of different stipulations if the damage likely to arise from those breaches is the same in kind;
v) But a presumption may arise if the same sum is applicable to breaches of different stipulations which are different in kind;
vi) There is no presumption that a clause is penal because the damages for which it provides may, in certain circumstances, be larger than the actual loss; and
vii) Where there is a range of losses and the sum provided for is totally out of proportion to some of them the clause may be penal.
He also said that even where the amounts were not genuine pre-estimates of loss, and were extravagant and unreasonable, this was “not necessarily conclusive. A commercial justification may mean that a clause which is not a genuine pre-estimate is not penal.”4 General Guidance He then stressed that there are limitations on the applicability of these guidelines003A5
1. The correct interpretation is fact and case dependent 2. Each of the guidelines is a rebuttable presumption 3. The wrong-doer has to prove that the term is penal based on the contract as a whole and
the context in which it was made. 4. The court “recognises the utility of liquidated damages clauses and that to hold them to be
penal is an interference with freedom of contract. It is, therefore, predisposed to uphold clauses which fix the damages for breach.”
5. “A pre-estimate does not have to be right to be reasonable”. 6. The bargaining power of the parties does not mean the court cannot intervene
Purpose of the Amount The court said that “the fact that a payment on breach may not really be a pre-estimate of loss does not mean that it must be penal. If there is a good commercial justification for the provision that may be a ground for deducing that deterrence of breach was not the dominant purpose of the term.”
Conclusion The starting point is that the parties have freedom to contract which means they can choose the terms on which they want to do business. You will have an uphill struggle to persuade the courts to allow you to avoid agreed terms.
The Author Sarah Fox of Enjoy Legal Learning wrote this note. She is a speaker and trainer who cuts through the complexities of construction law. She provides confidence to construction companies to read, use and understand their contracts. She is also author of the 500-Word Contract™. To find out how Sarah can help you love your terms and conditions, contact her on: 07767 342747 or by email: [email protected]
Footnotes
1 Makdessi v Cavendish Square Holdings BV & Anor [2013] EWCA Civ 1539. 2 Robophone Facilities Ltd v Blank [1966] 1 WLR 1428, Workers Trust & Merchant Bank Ltd v Dojap Investments Ltd
[1993] AC 573, Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company [1915] AC 79, Alfred McAlpine Capital Projects Ltd v Tilebox [2005] EWHC 281, Philips Hong Kong Ltd v Attorney General of Hong Kong [1993] 61 BLR 41.
3 Paragraph 71. 4 Paragraph 117. 5 Paragraphs 72-75.
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