Challenging liquidated damages

For 100 years the tests set out in Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79 were accepted as rules for deciding whether a liquidated damages clause was enforceable. These tests were as follows:

• the liquidated damages rate will be treated as a penalty if the sum stipulated is extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to have followed from the breach;
• the liquidated damages will be treated as a penalty if the breach consists only in not paying a sum of money, and the liquidated damages sum is greater than the sum which ought to have been paid;
• there is a presumption (but no more) that when a single lump sum 'is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage', this will be a penalty; and
• 'it is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.'

More recently, the strictness of this approach has increasingly been mitigated by the Court's willingness to look at the commercial justification for the liquidated damages, and an increasing reluctance to interfere with provisions which have been negotiated and agreed by experienced business people.

It is well settled that liquidated damages will not be treated as a penalty simply because there might be a situation where the clause could result in the innocent party recovering a larger amount than his or her actual loss (Philips Hong Kong Ltd v AG Hong Kong, Privy Council Appeal No.29 of 1991 (1993) 61 BLR 41). In this case the Privy Council also stressed that a court must be careful not to set too stringent a standard and that what the parties have agreed should normally be upheld.

The Court of Appeal in Cine Bes Filmcilik VE Yapimcilik v United International Pictures [2003] EWCA Civ 1669 emphasised that the court should look to the purpose of the liquidated damages clause at the time the contract is executed.

In Murray v Leisureplay [2005] IRLR 946 the Court of Appeal underlined its reluctance to strike down liquidated damages clauses and stressed that the courts should not concern themselves with the minutiae of each case, but should adopt a ‘broad and general’ commercial approach.

In Azimut-Benetti (SpA) (Benetti Division) v Darrell Marcus Healey [2010] EWHC 2234 (Comm), the parties entered into a contract for the construction of a 60m long yacht. A clause provided that on lawful termination of the contract by the builder, it would be entitled to 20% of the contract sum by way of liquidated damages. This provision was challenged as a penalty. Mr Justice Blair held that the clause was 'not even arguably a penalty',  that it was commercially justifiable, and that, in a commercial contract of this kind, what the parties have agreed should normally be upheld.

The Supreme Court reviewed and restated the law in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67.

The Supreme Court stressed that the four tests in the Dunlop case were never intended as anything more than guidelines and further developed and extended the modern trend towards recognising the commercial justification for the provision and the court's reluctance to interfere with provisions agreed between experienced business people.

The principles governing liquidated damages and penalties were re-stated as follows:

• the penalty rule only applies to provisions ('secondary obligations') which operate in the event of a breach of some other term of the contract ('primary obligations') and regulate the remedies which are available.  It does not apply to a primary obligation, such as a price determination or adjustment clause (this was the main basis for the decision in El Makdessi);
• when a secondary obligation is challenged as a penalty, the correct test to be applied is whether the sum in question is a penalty, not whether it is a "genuine pre-estimate". 
• the fact that a sum is not a 'genuine pre-estimate' does not of itself make it a penalty;
• a provision in a contract can only be a penalty if it provides an 'exorbitant' alternative to the common law damages recoverable in respect of a breach of contract;
• the legitimate interests of the innocent party may go beyond receiving compensation for the breach, and this can validly be protected by imposing an additional financial burden in respect of a breach;
• the sum will only be treated as a penalty if it is 'unconscionable' or 'extravagant' by reference to some norm, such as general industry practice (this was the main basis for the decision in Parking Eye);
• to be a penalty the detriment imposed on the contract-breaker must be out of all proportion to the legitimate interests of the innocent party; and
• in a negotiated contract between properly advised parties of equal bargaining power, the strong presumption is that the parties are the best judges of what is legitimate in a secondary provision.

Despite this re-formulation of the law, it remains the case that a rate of liquidated damages which constitutes a 'genuine pre-estimate' of the damage that is likely to flow from a breach will not be treated as a penalty.  That is clear.  On the other hand, the precise limits of the additional category now allowed by the Supreme Court, the 'additional financial burden' required to protect other 'legitimate commercial interests' for the time being remains unclear.