Penalty Clauses In Construction Contracts

Earlier this month the Supreme Court gave judgment in two combined cases concerning the law relating to contractual penalty clauses. In Cavendish Square Holdings BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67, the Supreme Court had the opportunity to review the law on penalties for the first time since the House of Lords case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847 a century ago. In both cases, the Supreme Court held that the clauses were valid and enforceable, overturning the Court of Appeal's decision in Cavendish (which was considered in a GD Online article of February 2014) and upholding the Court of Appeal's decision in ParkingEye.

Whilst Cavendish and ParkingEye are not related specifically to construction contracts, these cases will have a significant impact on how liquidated damages provisions in construction contracts are likely to be interpreted going forwards.

Penalty Clauses: The law before Cavendish and ParkingEye

It is a long-established rule of law that a clause which is deemed to be a penalty will be unenforceable. Liquidated damages clauses, by contrast, are enforceable. The purpose of a liquidated damages clause is to compensate the innocent party for breach of the terms of an agreement without the difficulty and expense of having to prove the actual loss. A penalty clause, on the other hand, functions to punish or deter a party from breaching the terms of an agreement and may well be disproportionate to the actual loss suffered by the aggrieved party.

The traditional approach in identifying a penalty clause, laid down in Dunlop, was to consider whether the specified damages were "a genuine pre-estimate of loss or a deterrent" - if the former, they were not a penalty.

Penalty Clauses: The law after Cavendish and ParkingEye

In Cavendish and ParkingEye, the Supreme Court was unanimous that the doctrine of penalties should not be abolished, but extended the traditional test set down in Dunlop, and provided useful clarification on subsequent case law. The Supreme Court held that:

The rule on penalties only applies to "secondary obligations", meaning obligations which only arise out of a breach of contract. The tests set out in in Dunlop will usually be adequate to determine the validity of a straightforward damages clause. In other cases, the concepts of 'genuine pre-estimate of loss' and 'deterrence' are unhelpful. The true test is "whether the impugned provision is a...