A commercial goal is won on penalties
Theresa Mohammed of Trowers & Hamlins explains how a legal judgment asserted commercial latitude on damages.
Liquidated damages provisions in construction contracts are always controversial because they have huge commercial consequences. In construction contracts, for example, failure to achieve a practical completion date could incur substantial costs to the client, such as temporary accommodation and compromise funding arrangements.
For clients, liquidated damages offer the certainty of recoverable damages when the contractor defaults in specified ways, such as culpable delay. This can be a welcome remedy, as trying to make and prove a general damages claim is an expensive and drawn-out process. For contractors, on the other hand, liquidated damages are viewed as penalties that should be avoided wherever possible.
Liquidated damages provisions are widespread in many types of contracts, as they are perceived to offer certainty of the consequences on certain defaults, and make recovery easier for the innocent party. This has led to high-profile projects having liquidated damages provisions that stipulate thousands of pounds per day to be paid in the event of a breach of contract.
When the stakes are this high, any attempt to levy liquidated damages will often be followed by a legal dispute if the contractor believes it can demonstrate the clause is an “unenforceable penalty clause”. Under English law it has been established that true penalties – those designed to exert undue pressure on a party to perform – will not be enforced by the courts.
The judicial reasoning from the commercial and construction courts had initially confirmed that, to be enforced, a liquidated damages provision should be a genuine pre-estimate of loss, and not extravagant and unconscionable in comparison with the actual loss that could be suffered. The assessment of what was a genuine pre-estimate had to be made when the contract was negotiated, not when the breach occurred, and this has become a point of contention.
As a result, a body of case law has developed with parties on one side trying to enforce liquidated damages provisions and, on the other, defaulting parties trying to resist such enforcement by arguing that the clauses are penalties.
It is also worth noting that the courts in general have shown reluctance to strike out liquidated damages provisions if it can be argued that there is a commercial justification for them, and that their predominant function is not deterrence.
In a case heard in January in the London commercial court, Edgeworth Capital (Luxembourg) and Another v Ramblas Investments, the parties had entered into a financing agreement to purchase a building in Spain where a large “upside fee” linked to certain “payment events” – such as defaulting on a loan or early repayment – was payable.
The inclusion of such “payment events” in contracts has led some to describe them as liquidated damages in disguise. So this case has prompted interest in how such provisions are interpreted by the courts. In this case, there was a dispute over whether this upside fee provision was an unenforceable “true” penalty or whether it was a disguised penalty.
The defendant, Ramblas, argued that the upside fee was a penalty, as it was triggered in fact by its individual property investors breaching a personal loan agreement, rather than Ramblas being in breach, and also that the €105m fee was not a genuine pre-estimate of loss and exceeded the amount of recoverable damages Edgeworth would have incurred.
Mr Justice Hamblen considered the law on penalties, and that the rule against penalties only applies in the event of a breach of duty owed to the other party. In other words, the “upside fee” could only be considered a penalty if it was triggered by a breach by Ramblas.
The judge reviewed the terms of the upside fee and decided that it was not a pre-estimate of loss. He went further to say that, despite this not being a genuine pre-estimate, if the penalty rule was applicable, the clause was commercially justifiable as a charge for the provision of the junior loan and the predominant function was not deterrence. This resulted in judgment in favour of the claimant for the full upside fee.
What this means for contract drafters is a seismic shift from concerns over demonstrating pre-estimates of loss to focusing on what can be commercially justified. To take a construction example, such as culpable delay of a high-profile hotel reopening, it is easy to see that there would be a commercial justification for a very high level of liquidated damages.
As such, the Edgeworth Capital case offers a useful revision of the law on penalty clauses and some helpful food for thought when it comes to drafting construction contracts.
This may be the start of a trend towards the development of payment terms in construction in the hope that they provide a more readily enforceable commercial recovery than higher-risk, default-based, liquidated damages provisions.
Theresa Mohammed is a contentious construction partner at law firm Trowers & Hamlins