When do liquidated damages add up to an unenforceable penalty?
English law enforces the terms that contracting parties see fit to agree. One exception to this rule is that the court can strike down what it regards as penalty clauses, writes Sue Lindsey. Arguments can arise about whether a high level of liquidated damages stipulated in a contract make a particular provision a penalty and therefore unenforceable. A recent judgment by Mr Justice Jackson in the case of Alfred McAlpine v Tilebox (25 February 2005) gives helpful guidance about how the court tests such clauses.
McAlpine contracted with Tilebox to carry out a speculative refurbishment. Liquidated damages were agreed at £45,000 per week. Tilebox already had an agreement with Standard Life, which had a long lease on the building.
Standard Life was to pay Tilebox a fixed fee plus a development completion payment (DCP). There was a formula for calculating the DCP. The effect of delay to the building contract would be to erode the DCP payment to Tilebox.
The works are still unfinished. The extended completion date was August 2002. Having acknowledged that there would be a delay for which no extension would be given, McAlpine challenged the liquidated damages clause: is the requirement to pay £45,000 per week a penalty and therefore unenforceable? Having reviewed the law, the judge concluded that:
. For a pre-estimated sum in damages to be enforceable, it has to be reasonable. That does not mean it has to be right. For the sum to be unreasonable, there would have to be a substantial discrepancy between contractual damages and the level of damages likely to be suffered.
. Although many cases refer to a 'genuine' preestimate of loss as the test for an enforceable clause, if the estimate is wrong, its genuineness cannot save the clause. The court will objectively test for itself whether the stipulated sum was reasonable at the time the contract was made.
What were Tilebox's potential losses? First, the decrease in the DCP, and second its direct losses.
There was a possible third loss, which depended on the interpretation of Tilebox's contract with Standard Life. If Tilebox had an obligation to ensure the works were finished by a certain date, then it had a potential liability to Standard Life for any delay. Damages would be measured on the basis of lost rent. The judge concluded that Tilebox did have such an obligation. All agreed that lost rent would be about £45,000 per week.
So the judge decided the liquidated damages provision was reasonable.
But he went on to say that, even if that contractual interpretation was wrong, the liquidated damages clause was still reasonable on the basis of only the first two elements of Tilebox's probable losses: the reduced DCP and direct losses.
The judge concluded that, when the building contract was made, it was possible that the final DCP could have fallen anywhere between nil and £1.7 million. Making an objective assessment of what, when the contract was made, the weekly erosion of the DCP could reasonably have been estimated to be, the judge reached a figure of £30,000. A similar objective assessment of a reasonable forecast of Tilebox's direct losses was £5,000 to £10,000 a week. Given those figures it was most unlikely that Tilebox's total loss would be as much as £45,000 per week. But the judge concluded that the liquidated damages clause was not a penalty, on grounds that included:
. £45,000 was not so high as to make the clause a penalty;
. the inherent difficulty in such contractual arrangements of estimating the losses made it particularly sensible for these parties to have agreed a weekly figure, making it probable that that was the bargain the parties had intended;
. the court was predisposed to uphold contractual terms fixing levels of damages, particularly in the case of a commercial contract between parties of comparable bargaining power.
So, liquidated damages should be fixed by making a reasonable estimate of the losses that might flow from delay. In the event of a challenge, the court will make its own objective assessment of what is reasonable, taking into account all the contractual circumstances.
Susan Lindsey is a barrister at Crown Office Chambers. Visit www. crownofficechambers. com