evonshires
solicitors
CONSTRUCTION LAW UPDATE:
A Moder n Approach to Penalty Clauses
You should read this Update if:
•
You use or have considered using liquidated damages clauses in your construction contracts;
•
If you are challenging such a clause; or
•
You are defending against a claim that a liquidated damages clause in your construction contract amounts to a penalty.
Makdessi v Cavendish Square Holdings BV
[2013] 1 All E.R. (Comm) 787 and Talal El
Makdessi v Cavendish Square Holdings BV
[2013] EWCA Civ 1539
‘goodwill’ payments and that he was obliged to sell his
shares at the reduced price. The defendant questioned
the validity of the relevant clauses on the grounds that
they were penalties.
Summary
This case involved both a first instance judgement and
successful appeal in the Court of Appeal (CoA). It is
not directly a liquidated damages case, but clarifies the
evolving ‘modern approach’ to the law on penalties.
This is relevant to all construction contracts containing
liquidated damages clauses.
The First Instance Decision
The Facts
Burton J considered that the law has moved beyond
this simple dichotomy. That is to say, if there is some
other commercial justification for the clause it may be
valid even if it is not a ‘genuine pre-estimate of loss.’
The case concerned a share sale agreement which
provided for ‘goodwill’ payments to the seller and
restrictive covenants on the seller competing with
the company concerned. In the event that the seller
breached those restrictions, the contract required he
forfeit the goodwill payments and entitled the purchaser
to purchase the seller’s remaining shares at a reduced
price.
Subsequent to the agreement the seller/ defendant
breached his fiduciary duties to the company (which he
admitted). The company/ claimant brought a claim for
a declaration that the defendant was not entitled to the
Burton J reviewed the authorities on penalties. In his
view the law had previously drawn a simple dichotomy
between ‘genuine pre-estimates of loss’ (i.e. liquidated
damages) and penalties (i.e. clauses intended to deter
breach). Accordingly the only relevant question was: is
the clause a genuine pre-estimate of loss?
He went on say that the modern approach is to
consider whether:
1. There is a commercial justification for the clause;
2. The clause is extravagant or oppressive;
3. Its main purpose is to deter breach; and
4. If relevant, it was negotiated on a level playing field.
He found that, although the clause in question was not
a genuine pre-estimate of loss, it was valid. It served
a twofold commercial purpose namely: to adjust
consideration between the parties and to decouple
them, in the event of a breach. The clause was not
oppressive and had not been intended simply to deter
breach.
The Decision on Appeal
The CoA overturned this judgement. Whilst agreeing
with the approach adopted by Burton J, they found
that the clause in question was extravagant to such
an extent that it was not commercially justified.
The CoA agreed that “the fact that payment on
breach may not really be a pre-estimate of loss does
The fact that payment on
breach may not be a pre-estimate
of loss doesn’t mean it must be
penal.
not mean that it must be penal.” It also agreed that
the four considerations outlined by Burton J were
the relevant ones. However it provided clarification
on how these considerations would interrelate, and
consequently came to a different decision.
According to the CoA, the first question is whether
the clause is a genuine pre-estimate of loss, if so it is
valid. If not, this need not be fatal. The next question
is whether it is extravagant or oppressive. This will
largely turn on the facts of the case, however the main
consideration will be whether the amount to be paid/
lost by the defaulting party is “out of all proportion to
the loss attributable to the breach.” If so it is most
likely to function as a deterrent and unlikely to serve a
justifiable commercial purpose.
This decision brings the ‘modern approach’ more
closely in line with the ‘pre-estimate of loss’ approach
by limiting the circumstances in which clauses
which are not pre-estimates of loss can be held
‘commercially justifiable.’
Implications
The main implication of these decisions is that
assessments of whether liquidated damages clauses
are valid are likely to become more fact sensitive.
In a sense this will increase the certainty of such
provisions as courts will be less likely to overturn them
even if they do not amount to pre-estimates of loss.
Consequently, however, in cases where clauses are
not genuine pre-estimates of loss it will be far harder
to determine whether or not they are valid, each case
turning on its own particular facts.
Some Practical Advice
Liquidated damages clauses should still be drafted to
cover genuine pre-estimates of loss; such clauses will
remain valid and enforceable.
Effort should be made to evidence the calculations/
assessments on which such pre-estimates are
based. This may prove useful in the event such
clauses are challenged.
The ‘commercial justification test’ should only be
resorted to where a clause has failed the ‘preestimate of loss test.’
Finally it is worth considering whether clauses that
appear penal can be reformulated. If clauses that
specify obligations to make payments/ forfeit sums
following a breach can instead be expressed so as to
make certain payments conditional on performance,
the question of whether they are penal will not arise as
their operation will not be dependent on any breach.
Contact us
This is one of a series of regular updates from the
construction engineering department. For advice
on any of the above issues, or if you have any
suggestions for topics you’d like us to cover next,
please do email us at construction@devonshires.
co.uk. This is a new initiative so please share this
article among your colleagues and contacts and
encourage them to subscribe via the same address.
The tiny print
No action should be taken on the matters covered by this leaflet
without taking specific legal advice.
Find out more
This is one of a series of regular updates from the Construction & Engineering Department. For advice on any of the
above issues, or if you have any suggestions for topics you’d like us to cover next, please do email us at construction@
devonshires.co.uk. This is a new initiative so please share this article among your colleagues and contacts and encourage
them to subscribe via the same address.