BetterLawNotes-5 (2)

CONTRACT LAW

An award of agreed, or liquidated, damages differs from a conventional award of compensatory damages (which are termed unliquidated damages) in that liquidated damages are fixed by the parties in the contract itself.

An award of such damages differs from the award of an agreed sum (see below) in that the former involves the enforcement of the defendant’s secondary obligation to compensate while the latter involves the enforcement of a primary obligation. However, an agreed damages clause will not be enforceable if it is deemed to be a penalty.

When will a clause be a penalty?

The leading authority on when an agreed damages clause will be a penalty is now Cavendish Square Holding BV v Makdessi. Before looking at that case it may help to consider two earlier cases which established alternative approaches.

Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79

C had sold tyres and tyre-covers to D, D agreeing not to re-sell them at prices below C’s list prices. D agreed to pay £5 by way of liquidated damages in the event of any breach. D sold a tyre-cover at less than the list price. The House of Lords held that the liquidated damages clause was valid and enforceable.

‘The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage.’

(Lord Dunedin).

Lordsvale Finance plc v Bank of Zambia [1996] QB 752

Colman J held that a clause in a loan agreement, which provided for an increase in the applicable rate of interest in the event of default, was enforceable and would not be struck down as a penalty. Colman J said that the clause, the effect of which was to increase the consideration payable under an executory contract, was commercially justifiable and its dominant purpose was not to deter the defendant from breach.

Cavendish Square Holding BV v Makdessi [2015] UKSC 67

C agreed to buy a majority stake in D’s advertising business for a sum up to $150m, payment of $80m of which was deferred. D agreed to various non-competition and non-solicitation restrictions. It was agreed that should D breach these restrictions, the deferred consideration would cease to be payable. D did breach the restrictions and C refused to pay the deferred consideration. The Court of Appeal held that the clause providing for non-payment of the deferred consideration was intended to act as a deterrent and did not represent a genuine pre-estimate of likely loss. As such the clause was unenforceable as a penalty. The Supreme Court allowed C’s appeal.

ParkingEye Ltd v Beavis [2015] UKSC 67

C operated a shopping centre car park owned by T. Customers were permitted to park for free for a maximum of two hours, after which a charge of £85 became due. D left his car in the carpark for longer than two hours but refused to pay the £85 charge. The Supreme Court held that the charge was not unenforceable as a penalty and, by a majority, that the charge was not unenforceable under the Unfair Terms in Consumer Contracts Regulations 1999.

Lord Neuberger and Lord Sumption (with whom Lord Carnwath agreed):

[31] ‘. . . The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss . . . The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. To describe it as a deterrent (or, to use the Latin equivalent, in terrorem) does not add anything . . . The question whether it is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced are “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to some norm.

[32] The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin’s four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.’

[35] . . . In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.’

WHEN IS A ‘PENALTY’ NOT A PENALTY?

As Lord Neuberger and Lord Sumption make clear, for an agreed sum to be unenforceable as a penalty, the obligation to pay the sum must be a secondary, rather than a primary, obligation. In other words, an agreed sum which is payable otherwise than on a breach of contract will not be unenforceable as a penalty.

Export Credits Guarantee Department v Universal Oil Products Co [1983] 1 WLR 399

Under the terms of an agreement between C and D, D undertook that it would pay a certain sum to C in the event that D was in breach of its contract with T. The House of Lords held that the provision in a contract between C and D for payment of a sum by D on the occurrence of a specified event not being a breach by D of the contract with C could not be a penalty.

WHAT ARE THE CONSEQUENCES OF AN AGREED SUM BEING HELD A PENALTY?

‘Where the court refuses to enforce a “penalty clause” . . . the injured party is relegated to his right to claim that lesser measure of damages to which he would have been entitled at common law for the breach actually committed if there had been no penalty clause in the contract.’1

Robophone Facilities Ltd v Blank [1966] 1 WLR 1428 (Diplock LJ).

The effect of an agreed damages clause being held to be a penalty is merely that the (secondary) obligation to pay the agreed sum is unenforceable. But the injured party can still claim (unliquidated) damages for the breach in the usual way.

WHAT IF C WOULD HAVE SUFFERED NO LOSS?

It does matter that the breach has actually caused the innocent party no loss: it is still entitled to claim the agreed sum, for that is what the parties agreed.

Clydebank Engineering and Shipbuilding Co v Don Jose Ramos Yzquierdo y Castaneda [1905] AC 6

The defendants undertook to build four torpedo boats for use in the 1898 Spanish-American war. The contract provided that the defendants were liable to pay £500 for each week’s delay in the delivery of each of the boats. The claimants successfully recovered under this provision when delivery was delayed, notwithstanding that if the boats had been delivered on time they would have been sunk along with the rest of the Spanish fleet.

WHAT IF C WOULD HAVE SUFFERED GREATER LOSS?

In the same way, the agreed damages clause applies notwithstanding that the injured party’s loss may in fact be substantially greater than the stipulated sum.

Diestal v Stevenson [1906] 2 KB 345

A contract for the sale of coal stated that for every ton not delivered or accepted, the party in default should be liable to pay the sum of one shilling. The seller brought an action for non-delivery and was held to be limited to this sum notwithstanding that his actual loss was greater.

You cannot copy content of this page