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Liquidated Damages clauses appear in most construction and engineering contracts providing for agreed amount of damages to be paid upon a specific performance breach (for example, late completion). However, a landmark judgment handed down by the Supreme Court in the conjoined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis, now requires renewed focus on them. The Court’s decision will be of interest to contract teams, in-house counsel and lawyers practising in the sector alike, particularly as breach of contract and the consequences that flow from that are being brought into sharper focus as a result of the challenges facing the industry at present.
The key point to take from this judgment is that the Supreme Court has upheld the principle of the penalties doctrine, that is, that damages will be unenforceable where they constitute a penalty or are intended to “punish” the party in breach. However, the Court has reformulated the classic test. There has been a move away from focusing on whether a provision provides for a “genuine pre-estimate of loss”. The reformulated test instead focuses on whether a provision is intended to protect legitimate interests and considers whether the detriment is out of proportion to those interests.
In applying the penalties doctrine, courts over the last century have focused on the distinction between (i) contract provisions which provide for a genuine pre-estimate of loss and are therefore enforceable in the event of a breach, and (ii) penalty clauses which are designed to have a deterrent effect, and as such are unenforceable. The intention has been to prevent one contracting party from recovering a sum of money from the other which bears little or no relationship to the loss actually suffered as a result of the breach of contract. This formulation has been criticised by many, particularly in the field of commercial contracts, as amounting to an interference with freedom of contract.
The Supreme Court upheld the validity of the disputed clauses in both of these cases, with Lord Neuberger and Lord Sumpton agreeing that “the true test is whether the...provision...imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the...obligation”.
Therefore, when drafting clauses of this nature, contract teams should consider both (i) the legitimate interest that the clause is defined to protect and (ii) the proportionality of the detriment to the interest of the innocent party.
The new focus on legitimate interests recognises that compensation is not necessarily the only interest that the innocent party may have in the event of a breach. In these cases, the Supreme Court recognised the legitimate interests of contracting parties in measuring the value of a business in the event that goodwill is detrimentally affected and in the efficient management of a business model.
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