Late completion of construction works can be very expensive. You might be unable to trade, lose an anchor tenant or in a residential development, be unable to sell off units to pay off building costs and achieve a profit.
Building contracts will usually provide expressly for the recovery of damages in the event of delay. It can be a costly business to prove exactly what the costs of delay actually are.
For the contractor, the uncertainty as to the level of damages makes it difficult for them to know how best to respond to delay. Should they throw more resources at the development (at their own cost) or suffer the claim to damages?
Most commercial projects are procured on building contracts providing for liquidated damages in the event of delay. These clauses benefit both employer and contractor. The employer does not have to spend time and money proving his exact losses where there is delay. Typically, he will simply calculate the number of days/weeks of delay and multiply it by a sum provided in the contract as the daily/weekly rate for delay. From the contractor’s perspective, he knows in advance what he will suffer as damages for delay and can make his decision as to what resources to use to complete the project, so as to save the liquidated damages.
These liquidated damages clauses are often wrongly described as “penalty clauses”. A clause which provides for liquidated damages (the purpose of which is to compensate for breach of contract) are upheld by the courts. The courts do not uphold clauses which are intended as a penalty to deter a breach of contract.
To know whether a clause is a penalty or not has been simple to state in the past. The rate for liquidated damages was required to be a genuine pre-estimate of the loss which would be incurred in the event of delay. That said, it can often be quite difficult to estimate the effect of delay. However, a genuine “guess” was sufficient.
The Court of Appeal has now considered “penalty clauses”. This was not in the context of a construction contract, but the court’s judgment will affect liquidated damages clauses in building contracts.
The case the court looked at was a dispute arising out of the sale of advertising businesses in the Middle East. Mr El Makdessi was an influential figure in the Middle Eastern marketing world. He was one of the owners of a holding company which in turn owned the largest advertising and marketing communications group in the Middle East. In 2008 Mr Makdessi and another shareholder sold a 60% stake in the company to Cavendish Square Holdings.
Under the sale agreement Mr Makdessi gave certain restrictive covenants in favour of Cavendish and agreed not to compete with the group companies or solicit their clients. In the event of a Mr Makdessi would not be entitled to certain payments. The financial consequences to Mr Makdessi of being in breach were severe. Not only would he lose certain payments, but he would be forced to sell his remaining shares at an under value.
Cavendish claimed Mr Makdessi was in breach of the agreement and sought to rely on the restrictive covenants. Mr Makdessi argued that the terms of the agreement dealing with what would occur in circumstances of breach of the restrictive covenants were penalty clauses.
The Court of Appeal analysed the law on penalties and the principle of liquidated damages and set out what it said was the modern approach to dealing with such clauses. The test is now:
- Is there any commercial justification for the liquidated damages clause?
- The clause must not be extravagant or oppressive
- The purpose of the clause must be to compensate the loss and not to deter a breach
- The court will also look at whether the parties to the contract are on an equal footing.
You could be forgiven for thinking that the “modern approach” has made the picture more confused and uncertain. Liquidated damages which are genuine pre-estimates of loss and can be evidenced as such will still meet the requirements of the “modern approach”. When drafting a building contract it will be preferable to approach the liquidated damages in the old fashioned way.
Ascertaining whether a clause is a penalty or not will be open to greater debate and may mean that courts find clauses to be acceptable when in the past they would have been found to be penalties.
Deborah Ritchie is a Partner specialising in Construction Law. For more information please contact Deborah or another member of the construction solicitors team on 0800 024 1976 and they will be happy to assist.