Beyond the Fine Print: Are Penalty Clauses Enforceable?

English law recognises the autonomy of contracting parties, subject to some exceptions in terms of consumer contracts and tenancy agreements. Parties are generally free to agree to the law applicable to their contract (English or other), form and method of termination, consequences of breach including type of damages and dispute resolution mechanism (arbitration, mediation etc). In exercise of this autonomy parties may enter a clause which predetermines consequence of a breach, typically delineating a sum payable on breach by one party. This is called a “liquidated damages clause” (LDC). 

LDCs are used very widely in construction contracts, and are provided for by the widely-used standard form contracts such as JCT and NEC. In those contracts, they provide both Employers and Contractors with certainty at the outset as to the quantification of damage suffered by the Employer where the works are delayed. They provide a significant benefit to Employers in removing any requirement, during and after the works, to prove actual loss as a result of delay.

Though parties are free to agree to LDCs its enforceability depends on the nature of this clause.  If an LDC is determined to be a penalty, then it shall not be enforceable under English law. If such a determination is made it may have a significant impact on contracting parties’ bargains and in some cases their business. 

This article briefly looks at classification, applicable test and enforcement standard of LDCs. 

Is my LDC a penalty clause?

Usually where a LDC is in operation the contractual obligation that has been breached is classified as the primary obligation and the payment obligation under the LDC is classed as the secondary obligation. 

Traditionally, it was understood that the ultimate test to determine whether an LDC is an unenforceable penalty clause was to ascertain if the stipulated sum of damages was a “genuine pre-estimate”. Whether or not such estimate was “genuine” was judged with reference to that at the time of entering the contract a party would suffer the loss should a relevant primary obligation be breached. Meaning that the LDC will not be enforceable if as a matter of interpretation, the stipulated sum is found to greatly exceed the greatest amount of loss that could be proven to be caused by the breach of the relevant primary obligation; thus the stipulated sum is unconscionable. 

The foregoing approach was (partly) altered by the Supreme Court in Cavendish Square Holding BV v Makdessi; ParkingEye Ltd v Beavis (Consumers’ Association intervening) [2015] UKSC 67 and [2015] 3 W.L.R. 1373.

The Supreme Court clarified that:-

1. The penalty rule is not applicable to contractual provisions that are a primary obligation – it is only applicable to a secondary obligation (i.e. an obligation triggered by a breach of a primary obligation).
2. The distinction between primary and secondary obligations is a matter of substance rather than form or label. 
3. The question whether a particular clause is a penalty is a matter of objective interpretation as at the time that it was agreed, thus the circumstances surrounding the relevant clause are irrelevant.

Following from above the true test to determine the nature of LDC is to:- 

1. Determine by way of objective interpretation if the LDC is a primary or secondary obligation. 
2. If it is a secondary obligation then does it impose a detriment on the defaulting party which is disproportionate to any legitimate interest of the innocent party in the enforcement of the primary obligation, and 
3. Is the stipulated sum (or remedy) payable as a consequence of the breach is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract. 

The traditional test of comparing the stipulated amount and the greatest loss that could be proven to have been caused by breach of a primary obligation; gave way to the new test of comparing the stipulated amount with the legitimate interest of the innocent party in the performance of the contract.

What does this mean for LDCs in our present contract and future contracts? 

LDCs are a commercial and common-sense demand within certain sectors and types of contracts. That is especially when the full economic consequence of a breach may not commercially be quantifiable, and a stipulated amount provides commercial certainty. As mentioned at the outset, LDCs have had an important role in the construction sector and will continue to do so, within the bounds authoritatively established by the UK Supreme Court.

Parties should carefully assess, both in the context of existing agreements and when drafting future contracts, whether the LDC aligns with their legitimate interest. There is no strict definition of legitimate interest available, and any evaluation will be fact and sector specific – thus parties are best placed to analyse this for themselves. 

For future contracts parties may also seek to espouse LDCs as a primary obligation bypassing the need for a determination of nature of obligation and legitimate interest. This can be achieved through careful drafting.

For further information and legal advice on penalty clauses generally, please contact Michael Lewis or Prateek Sharma of our Litigation & Dispute Resolution team. For further information regarding construction contracts, please contact William O’Brien of our Construction, Engineering & Procurement team.