What Is a Penalty In A Building Contract? – The Legitimate Interests of Developers, Employers and Contractors in Enforcing Liquidated Damages in Building Contracts


“It’s a stone wall penalty. How the ref didn’t see it beats me……..” so Alan Shearer regularly exclaims on Match of the Day.

W hen will a Liquidated and Ascertained Damages (“LADs) clause be a penalty in a Building Contract? The answer now is whether it is in the “legitimate interests” of the Developer, Employer or Contractor that imposes and sets the level of LADs in the Building Contract. The courts have decided that only where they are “penal” in nature will they be struck down as a penalty and the question of whether LADs are a genuine pre-estimate of loss is no longer the question the courts should be asked in considering whether the LADs clause can be challenged or not.

This is because of the earth shattering Supreme Court decision of Cavendish Square Holdings -v- Talal El Makdessi and Parking Eye -v- Beavis [2015] UKSC67 that LADs clauses in Building Contracts cannot be challenged on the grounds that they are not a genuine pre-estimate of loss. They can only be challenged if they are regarded by the courts as “penal” and not because they are not a genuine pre-estimate of loss. The long established rule that unless LADs are a genuine pre-estimate of loss they will be an unenforceable penalty clause has been turned on its head by this decision and has

Agreeing the loss in advance

The Supreme Court ruled that it is contrary to freedom of contract for the courts to impose on contracting parties that they must set LADs as a genuine pre-estimate of loss.

Instead the Supreme Court in the Cavendish case ruled that whether the LADs clause is a genuine pre-estimate of loss or not is whether it is out of all proportion to a legitimate interest (of the developer, employer or main contractor) enforcing it.

Up until the Supreme Court decision of Cavendish the leading case on what constituted genuine liquidated damages was Dunlop Pneumatic Tyre Company -v- New Garage and Motor Company [1915] AC 79 86. The fact that the parties had labelled a clause “liquidated damages” was not conclusive and the essence of liquidated damages was that they were a genuine pre-estimate of loss. The courts would before the Cavendish decision have found that a clause described as a LADs clause was a penalty where the sum stipulated was greater than the greatest loss that could conceivably be proved by the Developer, Main Contractor or Employer.

When would the courts strike down a LADs clause?

Before the Cavendish decision the courts had been repeatedly asked to rule on whether the level of LAD’s was a penalty or not and they repeatedly came to the view they will not interfere with an agreement reached by the parties on the level of damages unless upon close examination they are found to be in no sense a genuine pre-estimate of loss.

In the Technology and Construction judgment of Alfred McAlpine Capital Projects Limited -v- Tilebox Limited [2005] EWHC 281 dealt with the question of when will an LAD’s clause be interpreted as a penalty clause? In this case the court decided there had to be a substantial discrepancy between the level of damages stipulated in the contract as LADs and the actual level of damages that were likely to be suffered before the courts would say that the agreed pre-estimate was unreasonable.

Mr Justice Jackson said “….In my view, a pre-estimate of damages does not have to be right in order to be reasonable…………….There must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered before it can be said that the agreed pre-estimate is unreasonable”.

The court said if the question of LADs was the subject of specific debate between the parties to the contract before the contract is executed and LADs was considered not only by the parties but also by their legal advisors then the court would find that the agreed liquidated damages was reasonable.

In another case, that of Steria v Sigma Wireless Communications Ltd [2008] B.L.R 79 the TCC decided that if the contract was freely entered into by substantial and experienced companies the court would not interfere with what had been agreed. If LADs had been agreed in debate beforehand, and even more so if lawyers were involved, they would not be able to ask the courts to conduct the after the event armchair inquest typified by Shearer unless it is a “blatent penalty”, that no-one could fail to see as completely outrageous.

“Out of all proportion to legitimate business interests” – the new test

The Supreme Court in Cavendish have now ruled that the test of whether a LADs clause is legitimate or not in a building contract is whether it is out of all proportion to any legitimate interest of the employer/owner/developer in achieving the target completion date.

The concern for contractors is that this will lead to the employer asserting any “legitimate interest” and to set an arbitrary sum. The lesson for Contractors and Sub-Contractors faced with a demand by the Employer or Main Contractor to agree to an onerous and excessive LADs clause is that they should keep a record of discussions about “legitimate interests” when agreeing LADs to avoid future disputes. There is no doubt though that the Cavendish decision will inflate the amount of LADs in the name of “legitimate business interests” and Contractors will cry foul that they are in truth “extravagant”, much like the dive of the striker on Match of the Day that “wins” or “claims” a penalty when none is justified.

If you need any advice and representation on contract drafting and negotiation or on contractual disputes give me a call for a chat on the best way to tackle them.

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