Liquidated damages and penalties

7 October 2014

Ben Worthington, Senior Associateben.worthington@olswang.com | + 44 20 7067 3541

What are liquidated damages?

•Definition of liquidated damages

•A pre-determined sum payable by the defaulting party in the event of a specified breach of contract

•Genuine pre-estimate of loss

•Liquidated v unliquidated damages

•Liquidated damages for non-delay related losses: Bluewater Energy Services BV v Mercon Steel Structures BV and others [2014] EWHC 2132 (TCC)

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Why use liquidated damages?

•Complexity of claims in construction disputes

•Saves time and cost

•Avoids dispute procedures

•Avoids need to establish loss

•Certainty

•Cost of delay is clear –incentivises

•Risk of delay easier to price

•Limits liability

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Are liquidated damages an exhaustive remedy?

•a liquidated damages clause normally covers all damages for non-completion

•Temloc Ltd v Errill Properties Ltd (1987) 39 BLR 30

•rate of LDs stated as "£nil”

•Court of Appeal held that parties had agreed that no damages would be payable for the breach in question.

•Biffa Waste Services Ltd and another v Maschinenfabrik Ernst Hese GmbH and another [2008] EWHC 6 (TCC)

•Biffa argued LDs was an exhaustive remedy only for delay not caused by a breach of any obligation

•claimed unliquidated damages for breach of obligations of reasonable skill and care which had caused a fire and, as a consequence, delay

•Held: no distinction between a ‘simple’ failure to complete and a failure to complete caused by another breach –LDs were ‘the only monies’ due for such default.

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Defences to claim for liquidated damages

A party may challenge the imposition of liquidated damages on the basis that:

•The liquidated sum is penal in nature

•The right to deduct LDs has not crystallised because:

•The breach is not within the scope of the clause

•A condition precedent for deducting LDs has not been complied with; or

•The clause fails for uncertainty: Bruno Zornow (Builders) Ltd v BeechcroftDevelopments Ltd [1990] 51 BLR 16

•Sectional completion and partial possession

•No date in contract

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Penalty clauses - introduction

•The court will not enforce penalty clauses

•BUT: difficult to establish that a clause is a penalty

•the courts are pre-disposed to uphold liquidated damages clauses:

•court reluctant to interfere in a commercial bargain

•contractor must establish penalty –high bar

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Penalty clauses – general principles

•Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79

•The use of the phrase “liquidated damages” in a contract is not conclusive

•Was the predominant function of the clause to deter a party from breaching the contract (a penalty) or to compensate the innocent party for breach (enforceable)

•The essence of a liquidated sum is that it is a genuine pre-estimate of loss, judged at the date of the contract, not as at the time of breach

•But see: Unaoil Ltd v Leighton Offshore Pte Ltd [2014] in respect of variations to contracts - where "...the contract is amended in a relevant respect, the relevant date is… the date of such amended contract."

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Recognising a penalty clause (1)

•Is the purpose of the clause to intimidate or penalise, or is to compensate?

•Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] EWHC 281 (TCC)

•Is the liquidated sum reasonable?

•Is the liquidated sum extravagant or unconscionable by comparison with the greatest loss that might be suffered?

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Recognising a penalty clause (2)

•Employer does not have to accurately predict its likely loss

•Philips Hong Kong Ltd v Attorney-General of Hong Kong

•“it will not normally be enough to identify situations where the application of the provision could result in a larger sum being recovered by the [Employer] than his actual cost”

•Court will investigate the background to the contract at the date the contract was entered - what is a reasonably foreseeable loss?

•If the Employer can show that he arrived at the sum with calculations / projections (e.g. loss of income, increased financing costs) then strong evidence of genuine pre-estimate

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The challenge succeeds…

•Unaoil Ltd v Leighton Offshore Pte Ltd

•Agreement in relation to an oil pipeline –price $75M

•LDs payable to sub-contractor if contractor breached agreement -$40m (stipulated as a “genuine pre-estimate of loss”)

•Contract price later varied –minimum price $55M

•The liquidated sum of $40 million was "manifestly one which could no longer be a genuine pre-estimate" given that the amendment reduced the total price.

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The challenge fails…

•Alfred McAlpine v Tilebox

•LDs = £45,000 per week

•2 year delay (LDs circa £5.5m)

• £45,000 - “at or slightly above the top of the range of possible weekly losses flowing from the delay”

•the gap between it and an appropriate yardstick “was not nearly wide enough to warrant characterising this clause as a penalty”

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The commercial justification test

Azimut-Benetti SpA v Healey

•Shipbuilding contract:

•buyer to pay shipbuilder $38M over 3 years

• In the event of a late payment, the builder could end the contract and retain (or recover) 20% of the contract price by way of LDs –any remainder would be repaid

•A common alternative to this was for the builder to retain all installments paid, build the yacht and then sell it - this could take a very long time for builder to realise its loss

•the purpose of the clause was not to deter breach of contract, it was commercially justifiable as providing a balance between the parties

•Both parties had the benefit of expert advice and terms were freely entered into

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The commercial justification test(2)

•Court of Appeal in Cavendish Square Holdings BV and another v El Makdessi [2012] EWHC 3582

•Rejected approach of rigid dichotomy between a genuine pre-estimate of loss, on the one hand, and a penalty on the other

•There are provisions which, while they do not reflect a genuine pre-estimate of loss, nevertheless have a commercial justification which means that their predominant purpose is not to deter breach

•starting point is to consider whether the relevant provision is extravagant and unreasonable

•Even if the sum is extravagant and unreasonable, not necessarily penal; a commercial justification for the provision may lead to conclusion that deterrent was not the dominant purpose of the term

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What if a challenge succeeds?

•party can claim general damages

•BUT the failed liquidated damages clause may act as a cap on the general damages

• limited case law on this point

•unlikely that an Employer can impose excessive liquidated damages and then avoid its effect to recover more

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Practical tips

•Be clear as to what event triggers the right to deduct damages

•Ensure that there is an adequate procedure for extending time

•Ensure LDs clause provides for sectional completion or partial possession i.e.

•It gives specific rates of LDs for specific sections

•reduces the rate of LDs if the employer takes partial possession

•Properly record any forecasts /estimates of loss / negotiations relating to the liquidated sum

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Any questions?