Knowledge Bank ~ Penalty Clauses – Reality over Hyperbole

After the UK Supreme Court reviewed the penalty clause doctrine last year – the first time in over a century – there has been a glut of excited commentary from the legal community on the impact this has on construction contracts. Personally I think it is simply a timely reminder to make sure you understand the application of liquidated damages and the definition of penalty clauses. It does not necessarily give the courts the power to rewrite commercial contracts.

Brief Overview of a Long History

It is common practice for commercial contracts to contain a ‘liquidated damages’ clause. The clause typically provides a base calculation for potential damages. For example construction contracts often provide for a fixed amount per day for late completion. The aim is that everyone agrees upfront damages due instead of leaving their quantification to the courts or an arbitrator. The origins of these clauses can be traced back to the seventeenth century, with numerous cases that support them. However such clauses – or rather the damages associated with them – have frequently been subject to challenge.

Whilst liquidated damages clauses are enforceable, penalty clauses are not. So when liquidated damages clauses are not proportionate to the loss, and when it appears they were intended to deter breach rather than to make it easier for the victim to recover damages – they are often legally challenged as a penalty clause which would make them unenforceable.

The most quoted case is Dunlop Pneumatic Tyre Co Ltd v New Garage Co Ltd [1915] – which was referred to and generally upheld in the 2015 ruling. Modern law predominately relates to the Dunlop Case and specifically the distinction between a “penalty” and a “genuine covenanted pre-estimate of damage”.

Although the distinction between “penalty” and a “genuine pre-estimate” may seem simple, it is complex in practice, with a high threshold of proof needed for those attempting to demonstrate that it is penal. The fact that the sum in question is wrong or in fact much larger than the loss that has arisen, is not a good enough reason for the damages to be reviewed by the court. During the recent review, the presiding judge commented ‘the touchstone is not the amount, but whether or not it is a penalty’.

Indeed, the requirement to prove there is some element of oppressiveness or extravagance was reinforced by Lord Woolf in Philips Hong Kong Ltd v The Attorney General of Hong Kong [1993].

It should now be clear that in practice the need to have a ‘genuine pre-estimate of loss’ is of limited importance – given that it can be incorrect and disproportionate yet still enforceable. What is key is demonstrating that there is nothing otherwise objectionable or extravagant. In this context it is worth remembering what Lord Dunedin said in the Dunlop case, where he contrasted a genuine pre-estimate with the stipulation of a sum that was:

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

Given this, it is very rare that the courts will strike down a liquidated damages clause in a commercial agreement.

The 2015 Judgements

Two cases were reviewed simultaneously by UK Supreme Court – whilst both were very different cases they were presided over together as based on the same rule of law. Cavendish Square Holding BV v Talal El Makdessi was related to a commercial purchase of a business and a non-competition clause, and rather oddly Parking Eye Limited v Beavis [2015] UKSC 67 was to do with a parking ticket. You can watch the eloquent summing up of the two cases by Lord Sumption here

Hopefully I have provided some clarity and dispelled some myths – however you may now be asking what has changed following on from these cases? Not much I would say!

Focussing on the Cavendish case, as it had a commercial basis, critically the Court was unanimous that the doctrine of penalties should not be abolished.

The pertinent conclusions from the review were:

• The traditional “genuine pre-estimate of loss” test no longer stands as reason to stroke down a liquidated damages clause. Case law shows that in practice this was already the case – it has simply been affirmed by the Supreme Court.

• Although formulations of the proper test vary – they do include “extravagance”, “unconscionability” and the “legitimate business interests” of the parties.

• The commercial bargaining power of the parties was deemed to be important – typically this only really applies to consumer contracts and is neatly summed up by the Supreme Court of Canada in Elsley v J G Collins Insurance Agencies Ltd [1978]: ‘It is now evident that the power to strike down a penalty clause is a blatant interference with the freedom of contract and it is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. It has no place where there is no oppression’.

The 2015 cases were UK Supreme Court judgements, and although we will only be certain how they will be interpreted by the Hong Kong and Singapore courts once a relevant case has been heard, it is not unfair to assume they will have an influence.

There has also been a lot of talk about a recent judgement in Australia, which exhibited a significant departure from this UK Supreme Court position – however this was a consumer case, so I would question its relevance to commercial contracts.

Practical Day to Day Implications

Given that there seems to be a call to carry out health checks and reviews of contracts, one has to ask whether this is not somewhat reminiscent of the need to ensure that your IT systems are Y2K compliant – which turned out to be a solution in want of a problem!

From my interpretation of the cases and my experience dealing with liquidated damages and contract causes I would make the following recommendations:

Contractors – unless you can demonstrate extravagance or unconscionability it would be reasonable to assume that all damages clauses are enforceable.

Clients – provided genuine efforts have been made to tie the damages clauses to the business interests – whether that be through a genuine pre-estimate of loss or some other mechanism, there is no reason why the clause in question would not be enforceable.

Although case law regarding an imbalance of power between both parties typically refers to consumer contracts, I would recommend caution in your contract drafting when sub-contracting to smaller entities. That said, I am of the opinion that generally speaking all standard form contracts will fall within the safe definition of damages.

Make the common sense assumption that the courts have a reluctance to interfere in freely agreed contracts, and therefore take care upfront when quoting and accepting liquidated damages clauses.