Legal questions: liquidated damages

23 March 2016

Shy Jackson explains the underlying principles behind liquidated and ascertained damages

When we signed the contract we were given an amount to insert as the weekly rate of liquidated damages for delay beyond the completion date. This is an office building development in the north of England, and my feeling is that the amount we agreed is much higher than the sum the employer may lose if we are late, especially as the rental market there is very slow. Can I challenge the amount on that basis? 

The general rule has been that liquidated and ascertained damages (LADs) were unenforceable if they amounted to a penalty but could not be challenged if they were a genuine pre-estimate of the loss the employer may suffer in the event of delay. This test has been considered recently by the Supreme Court, but it is worth going through some of the underlying principles first.

The benefit of LADs for an employer is that they do not need to put forward evidence of the actual losses caused by the delay, and can claim the agreed amount regardless. LADs also protect the contractor, as they fix the liability for delay when the actual losses may be higher than the agreed amount.

Whether LADs are enforceable is a question that is determined based on the position when the contract was agreed. It is not possible to take account of post-contract events. Employers will, therefore, often record in a note the basis for the LADs and how they have been calculated, to show that the amount is a genuine pre-estimate of loss at the time the contract was made.

LADs can, however, be affected by substantial changes to the contract. In Unaoil Ltd v Leighton Offshore Pte Ltd [2014] EWHC 2965 (Comm), the LADs were agreed when the contract value was $75m, and remained unchanged when the contract was varied to omit substantial parts of the works, reducing its value to $55m. It was concluded that as the LADs remained unchanged at the time of the variation they were not a genuine pre-estimate of loss.

Underlying principles

The courts, however, have traditionally been reluctant to find that LADs are a penalty and unenforceable. This approach and the underlying principles were considered in detail by the Supreme Court in the combined decision in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67.

The court reviewed the basis for the rule and how it has been applied. It held that the test is not just about whether the amount is a genuine pre-estimate of the loss. Similarly, it was not enough to say the clause is a deterrent because this can be a legitimate clause intended to affect how a party behaves.

The test is thus based on whether a clause is unconscionable or extravagant, but the court will respect the parties’ freedom to agree contractual terms. The strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision relating to the consequences of breach.

It was held that the true test is whether the LADs clause is a secondary obligation, which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. For Barry Beavis, this meant having to pay the £85 fine for overstaying the 2-hour limit in the car park, as the majority of the judges held the car park operator had a 'legitimate interest' in charging those who overstayed the time limits even if this extended beyond the recovery of any loss.

In practical terms, this decision may make it more difficult to challenge LADs clauses in construction contracts. It will not always be easy to identify what is a legitimate interest and when a clause will be regarded as unconscionable and being out of all proportion. It is still, however, important to ensure that thought is given to the basis for any LADs agreement and to what extent they reflect the likely loss in the event of delay.

Returning to the question, the issue of whether the LADs are enforceable will be looked at in the context of the circumstances when the contract was agreed, so it will not be possible to take account of subsequent changes in the market. The court will be reluctant to interfere in what the parties agreed, unless the amount is seen to go beyond the employer’s legitimate interest in seeking to avoid delay.

Shy Jackson is a Partner at Pinsent Masons LLP

Further information

• Related competencies include Contract practice
• This feature is taken from the RICS Construction journal (February/March 2016)