The hardy perennial of liquidated damages popped up again in a recent court action, which turned on whether the clause was a penalty, and unenforceable, or not

A liquidated damages provision permits the employer to recover a pre-agreed amount in the event that the contractor has failed, as a result of its own default, to achieve practical or substantial completion of the project on the due date. Such clauses are often standard.

If a contractor is faced with a claim for liquidated damages it has a number of defences. Perhaps the most important is the assertion that the liquidated damages provision is a penalty and therefore unenforceable.

The onus for showing that the clause is a penalty lies upon the contractor. A penalty clause is one that provides that upon breach of the relevant obligation in the contract (in this case, the requirement to complete on time) another obligation arises (the obligation to pay liquidated damages), which does not represent a “genuine pre-estimate” of any loss likely to be sustained.

A recent decision of the Technology and Construction Court, delivered on 25 February, revisited this question and considered the manner in which the “genuine pre-estimate” of the loss incurred by an employer should be calculated.

The case in question is McAlpine vs Tilebox. At the time of writing a full transcript of this decision was unavailable but it appears McAlpine entered into a contract on an amended form of the standard JCT With Contractor’s Design in relation to the development of commercial offices. Tilebox had acquired the leasehold of the property and entered into a development funding agreement (DFA) with a third party whereby the third party agreed to finance the development in return for a long lease on the property. In addition, Tilebox was entitled to a fee for managing the development and a development completion payment (DCP), which diminished if completion were delayed.

The contract contained a liquidated and ascertained damages clause. It appears that the liquidated damages sum included an allowance for the loss that would be incurred by Tilebox arising out of the erosion of the DCP.

Work on the project was delayed and McAlpine applied for a declaration that the damages clause was a penalty and therefore unenforceable. Tilebox stated that the rate of damages provided for in the clause was a genuine pre-estimate of the loss calculated at the time the contract was entered into, that the DFA imposed a continuing liability on it and that its foreseeable losses included that liability.

The court confirmed that in order for a liquidated damages provision to be a penalty there would have to be an unacceptable difference between the pre-estimated damages and the damages that the employer was likely to suffer. Second, the test for whether a clause was a penalty clause did not turn on the honesty of a party: the test is primarily an objective one.

Finally, in relation to the inclusion of losses related to the erosion in the DCP, the court agreed that the DFA did impose a continuing liability on Tilebox and in these circumstances, even without taking into account the diminution in the DCP, the payment by McAlpine to Tilebox at the rate specified in the liquidated damages clause was reasonable. The fact that a DCP had eroded to nothing did not mean that the inclusion of an allowance for erosion in the clause made it a penalty.

The decision in McAlpine is useful in reminding us of the general approach taken by the courts to the construction of these clauses. It is important to attempt to arrive at a genuine pre-estimate of the loss that is likely to be incurred and for the employer to ensure that all elements of this loss are considered and are defensible. And the court will make its decision on the basis of the facts at the time the clause was entered into, not in the light of later events.

Simon Lewis is a partner in solicitor Dickinson Dees in Newcastle upon Tyne