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Damage Control: Redefining The Test For Liquidated Damages

Damage Control: Redefining The Test For Liquidated Damages

Earlier this month a bench of seven Supreme Court judges handed down a decision in the joint appeal of ParkingEye and Makdessi. The general impact of this judgement was considered in Stuart Murdoch’s blog of last week. However, the ParkingEye and Makdessi appeal has particular relevance to the construction industry in respect of liquidated damages, which will be considered in this blog.

Calculating Liquidated Damages

In most cases, opting to impose liquidated damages in a building contract will extinguish the right of the employer to seek common law damages.  This is mutually beneficial – the contractor gets certainty about its exposure to liability for (most commonly) delay, and the employer is spared the time and inconvenience of seeking a remedy through dispute resolution.

The sum selected is crucial. Employers seeking to impose liquidated damages must carry out a balancing act between selecting a sum high enough to provide adequate relief against the losses actually experienced, but not so high that it will fall to be a penalty clause. Penalty clauses (clauses that seek to penalise a contract breaker) are unenforceable at common law.  To get this balancing act right, the golden rule for the last 100 years or so has been to make sure the figure is no greater than “a genuine pre-estimate of the loss” that the employer would incur.

So what’s changed?

In the new ParkingEye and Makdessi decision, the court expressed the view that the “genuine pre-estimate of loss” test was unhelpful as it had too often been treated as a code. In redefining the test, the court set out a wider assessment of what constitutes a penalty clause:

  1. Only secondary obligations can be construed as a penalty clause (secondary obligations are those that set out the consequences of failing to comply with the main contract terms).
  2. The party seeking to enforce the clause must have a legitimate interest in doing so; otherwise it may fall to be a penalty.
  3. The clause will be a penalty if it is extravagant, exorbitant or unconscionable.

The most notable difference is the focus on legitimate interest. Legitimate interest is much wider than quantifiable loss, and may include interests that are not financial in nature (eg. the maintaining of business reputation).

What impact will this wider test have?

Employers will have a greater capacity to apply liquidated damages as a means of deterring the contractor from breaching the contract, even in cases where it would experience no loss, as long as they have a legitimate interest in doing so.

On the other hand, contractors will likely find it more difficult to persuade adjudicators, arbitrators and the courts that a sum of liquidated damages in a building contract constitutes a penalty clause and should be struck out in place of general damages.

Employers may still find the genuine pre-estimate of loss test a good starting point for an assessment of liquidated damages. The figure should take proper account of every possible consequence of the contractor’s breach so as to adequately protect the employer, whilst also being commercially acceptable to both parties.

For a more in depth analysis of the ParkingEye and Makdessi appeal please see Colin Clelland’s legal briefing on this topic.

Kate Hannah