Whack a huge interest rate on late payments and it may be considered an unenforceable penalty. Go too low and you fall foul of the Late Payments Act
Once in a while, a legal case is referred to sufficiently often that it becomes a well-established principle. An example is Dunlop Pneumatic Tyre, the case that in 1915 established that a contractual penalty clause was unenforceable. This is a decision familiar to many in construction because of its application to liquidated and ascertained damage provisions. However, that well-established authority and principle has come under attack in a recent case concerning a football club.

The case of Jeancharm Limited vs Barnet Football Club Limited, decided by the Court of Appeal on 16 January this year, concerned a contractual clause providing for interest on outstanding sums of money in relation to the supply of football kits. The contractual rate was 5% a week. This resulted in a staggering 260% interest liability a year in the event of late payment. On the face of it, it might appear a pretty sound contention that this could not be a genuine pre-estimate of loss and was therefore a penalty clause and unenforceable.

However, the party with the benefit of the clause argued that the law had moved on from Dunlop to the extent that that case had been virtually abandoned and it was now a matter of looking at the contract as a whole and the balance of risks undertaken by each party. Specifically, it was argued that where the obligation to deliver under a contract was onerous, the risk could be balanced by an onerous interest clause.

The immediate problem with such an argument is that a review of the whole contractual bargain between parties would be needed before a decision could be made that a provision was or was not a penalty. This may be easily achievable in the case of the supply of football kits but could be a considerable and costly feat to undertake when it comes to risks under a building contract, where potential liabilities may run to tens of millions of pounds.

Given the act’s interest rate of 8%, the temptation to draft an alternative provision is perhaps compelling

The Court of Appeal decided that Dunlop still applied and that the interest provision has to reflect the greatest loss that could be perceived as arising from late payment at the time the contract was entered into. As it was plain that 260% was well beyond what could have been anticipated, it was not a genuine pre-estimate of loss, so it was a penalty and it failed accordingly.

Interest claims are now assuming greater significance in construction, particularly in adjudication claims, as a result of the Late Payment of Commercial Debts (Interest) Act 1998. The significance of this is that it actually places a term in a contract providing for interest to be chargeable unless the contract itself includes such a provision and provides a "substantial" remedy. The interest rate allowed under the act is 8% above base rate: quite substantial. Given such a rate, the temptation to draft an alternative provision is perhaps compelling. However, contract drafters need to beware that the provision may be found in breach of the act if it is not substantial. Eight per cent over base will then apply in default.

In reality, therefore, an act of parliament is altering the rationale behind Dunlop. Whereas the judge there looked at the parties and the specific loss to see if it was a genuine pre-estimate in relation to interest claimed, the Late Payment Act seeks to prescribe a rate that is immediately justifiable by reference to statute. There were many objections to the Construction Act on the basis that parliament was interfering unduly with contractual arrangements between private parties. The Late Payment Act is another example of the growing willingness of parliament to regulate private contractual relationships, a process that gained momentum in the late 1970s with consumer legislation, standard terms dealing with quality and performance and restrictions on unfair contract terms.