Liquidated Damages Following Cavendish

On 4 November 2015, the Supreme Court handed down judgment in joint appeals relating to Cavendish Square Holdings Ltd v Talal El Makdessi (the "Cavendish Appeal") and ParkingEye Ltd v Beavis (the "Beavis Appeal")1. These appeals provided the first opportunity for the Supreme Court, or the House of Lords, to consider the law concerning penalty clauses in approximately 100 years.

The two appeals related to non-construction-related disputes. The Cavendish Appeal concerned the effect of two clauses related to non-compete covenants in an agreement regarding the sale of a controlling stake in business. The Beavis Appeal concerned the enforceability of a parking fine.

As Andrew Weston sets out below, the Supreme Court judgment is relevant to construction contracts as it impacts upon the law relating to liquidated damages.

The most important proposition of law impacting on liquidated damages provisions typically found in construction contracts is derived from the leading judgment of Lord Dunedin in Dunlop Pneumatic Tyre Company Ltd v New Garage Motor Co Ltd (1915).2

Following Dunlop the test commonly applied was: are the liquidated damages a genuine pre-estimate of the loss (rendering the clause compensatory)? If so, the clause was unlikely to be regarded as a penalty. However, if the amount of liquidated damages bore absolutely no resemblance to the loss, was extravagant and unconscionable, and was intended to deter a breach of contract, the court would be more willing to construe it as an unenforceable penalty.

As a consequence, an employer did not need to prove that it had actually suffered the loss covered by the liquidated damages provision. The liquidated damages could be recovered even if its actual loss was lower, providing they represented a genuine pre-estimate of the loss. If not, the provision was open to challenge on the basis it was a penalty clause, and not recoverable as a matter of law.

The Cavendish Appeal

Mr Makdessi agreed to sell a controlling stake in the largest advertising group in the Middle East to Cavendish. The terms of a share sale agreement ("the Agreement") contained restrictive covenants requiring Mr Makdessi not to become involved in a competing business. The sanctions for default were that Mr Makdessi would:

(i) forfeit the balance of price payable by Cavendish for his shares; and

(ii) be required to transfer all his remaining shares to Cavendish at a price which excluded any goodwill value.

Mr Makdessi accepted he had breached the restrictive covenants, but he denied the clauses were enforceable on the basis they were penalties.

At first instance, Mr Justice Burton found that the purpose of the restrictive covenants was not to deter a breach of contract, but to adjust the consideration between the parties. Cavendish was entitled to assess the value of a breach of the restrictive covenants by reference to the greatest loss that could conceivably be proved to have followed from the breach, given the potential for a substantial impact on the...