Paying the penalty
Wednesday 9th December 2015
The law relating to liquidated damages has changed, with potentially significant implications.
The law on “penalties” has been changed by the Supreme Court in a non-construction case (known as Cavendish Square v Makdessi). It is potentially very significant. It affects the rules relating to liquidated damages (or “LDs” as they are known in the construction industry).
Everyone in construction is broadly familiar with the principle of liquidated damages, which is a way of pre-agreeing the level of compensation to be paid by a contractor to its employer in the event of culpable delay to practical completion. The damages are typically calculated by reference to a fixed rate per day or week of delay.
Liquidated damages can also be imposed to compensate for a shortfall in the net internal area of a completed building. In this case the rate might be applied for each square metre less than what was expected.
In short the established rule was that the liquidated damages rate must be a “genuine pre-estimate” of the loss which the employer expected to incur in the event that the works were finished late or fell short of the required area. The employer was not expected to predict accurately what the loss in fact turned out to be; it simply had to be able to show that it had genuinely applied its mind to what that loss might have been. If the courts held that the LDs rate was not a genuine pre-estimate, or was at a level which served as a deterrent against contractor breach, they would rule that it was a “penalty” in law and thus unenforceable.
The Supreme Court has now replaced this with the following rule. The LDs clause must not impose a detriment on the contract-breaker which is out of all proportion to any legitimate interest of the innocent party under the contract.
Accordingly if an employer inserts an LDs rate in a contract which is so high as to be out of all proportion to any legitimate interest of the employer in achieving the target completion date then it will be unenforceable. In many ways there is little difference at face value between this test and the old “genuine pre-estimate” test. Further, anyone who has negotiated many building contracts will know that, in the real world, the LDs which appear in a building contract are frequently well below a genuine pre-estimate of the employer’s loss. This is because otherwise the potential liability of the contractor would be too high a risk for it to take on. As every employer knows, the higher the LDs rate the more the contractor will bump up its tender price in order to cover the risk. There comes a point in most commercial negotiations where the employer is not prepared to pay a premium for the contractor to shoulder all the risk of project delay. Put differently, employers know that if the LDs rate is too high, the tendering contractors are likely to walk away.
So, in many ways it could be said that the commercial market will usually ensure that LDs are lower than what would be treated as a penalty. In many cases contractors should remember that an agreed LDs rate actually serves as a valuable limitation on its liability, precluding the employer from claiming any more than that (regardless of whatever greater loss he has actually suffered).
However the changes to the rule may have some implications which will emerge over time, particularly in the field of commercial leasehold property development. If there was a particular reputational value to the developer in achieving completion of a project by a particular time or to a precise set of dimensions or scale the LDs rate can now reflect this. The rate might be higher as a result and the courts would not treat this as a penalty, so long as it was proportionate to the developer’s legitimate expectations.
There is a further angle to watch out for following the Supreme Court’s ruling. In framing the new rule the Supreme Court has drawn a distinction between what is calls the “primary obligations” under a contract (ie the duty to complete the works on time or in line with a target area and for the other party to pay the price) and the “secondary obligations” (such as the duty to pay damages for delay in completion). Only secondary obligations can be treated as unenforceable penalties.
It is possible that lawyers may try to draft contracts so that the consequences of delay or failure to achieve certain criteria (such as floor space) are dealt with by means of price adjustment mechanisms. This might allow the contract sum to be reduced to reflect the reduced value of the development to the employer. Adjusting the price goes to the very heart of the primary obligations in the contract. Contractors should be very wary of such an approach, which could expose them to inflated liabilities. The courts cannot treat such primary obligations as unenforceable penalties, so a contractor cannot later on seek to challenge this type of price adjustment formula on those grounds.
In conclusion contractors should appreciate that they cannot any longer simply negotiate over LDs rates by suggesting that the rate is not a “genuine pre-estimate” of loss, nor that the rate sought by the employer appears to be so high as to serve as a deterrent against delay rather than as compensation. Instead , when negotiating over the LDs rate the contractor should seek to argue that the rate is a “disproportionate” consequence for delay, when compared with what the employer is seeking to achieve. That may involve some due diligence into the wider context of the employer’s project, who the various stakeholders and interested parties are, and looking to establish whether there are any other perhaps non-monetary features of the project (such as prestige or reputation) the loss of which might be reflected in the damages recoverable in the event of delay or other non-performance.