Delay and Disruption - Application of Rules on Penalty Clauses© Daniel Atkinson 2006 2 July 2006PRACTICE NOTE
The difficulty of quantifying the loss at the time the contract is made
is a constant factor in the Court’s consideration whether an LD rate is a
penalty. The Court will consider the conduct of the Parties before the
Contract is made in determining whether the rate is reasonable, particularly
their view of the likely loss and negotiations as to the rate.
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In Clydebank Engineering and Shipbuilding Company Limited v Don Jose Ramos Ysquierdo y Castaneda and Others [1905] AC 6 the appellant defendants were late in delivering four torpedo boats to the Spanish Government. The House of Lords upheld the decision of the Court of Session that a clause providing for payment of £50 per vessel per week was valid and enforceable. The appellants argued that the loss flowing from the late delivery of a warship was extremely difficult to quantify and may on some scenarios be nil. Therefore, the clause should be struck down. The House of Lords rejected this argument roundly. The Earl of Halsbury, Lord Chancellor, expressed the view that the liquidated damages clause served a useful purpose, precisely because the true amount of damages was uncertain and difficult to assess.
In Campbell Discount Co Ltd v Bridge [1962] AC 600 the House of Lords struck down as a penalty a clause in a hire purchase agreement requiring the hirer to pay compensation for premature termination. The objectionable feature of this clause was that it provided a sliding scale which operated in the wrong direction. The less the depreciation of the vehicle, the greater was the compensation payable.
In Robophone Facilities Limited v Blank [1966] 1 WLR 1428, the Court of Appeal by a majority upheld a liquidated damages clause in a hiring contract. The relevant clause in this case was subject to closer arithmetical scrutiny than appears to have been applied earlier cases, before a decision was reached that this was a reasonable pre-estimate of the loss.
In the Court of Appeal in Ariston SRL v Charly Records Limited [1990] Charly specialised in the production and marketing of re-issues of quality popular records of jazz, blues and rock music. Charly obtained master tapes and the metal parts to press the records and artwork for the sleeves, but did not always own the copyright.
On 1 July 1982 the parties entered into an agreement for Ariston, an Italian company based in Milan, to produce long playing records and the sleeves for which Charly was to supply metal parts, lacquers, negative films and artworks which they did for 108 different records.. Clause 7 of the agreement provided for Ariston to return the metal parts, lacquers, negative films and artworks within 10 days of request and if they failed to do so to pay £600 per day for each days delay in delivery of the parts.
On 13 February 1985 Charly requested Ariston to return the metal parts, lacquers, negative films and artworks. Not all items were returned. Charly claimed £600 per day for 33 days it claimed that Ariston had detained some or all of the parts. Ariston claimed that the clause was unenforceable.
Charly had estimated a profit of £1.38 per record and an estimated minimum sale of 300 records per month, so for 108 records the daily profit was £1,408. During negotiations Ariston would not agree the sum of £1,408 but instead agreed the sum of £600 per day. The judge at first instance found that the overwhelming reason for the clause and the sum of £600 was to get the parts back quickly and that this was far removed from a pre-estimate of damages. Although the sum of £600 had been derived from a calculation, the overwhelming reason was to try and persuade or force Ariston to return the parts within the stipulated period. The judge concluded that the clause was intended to apply even though the items retained were few in number and would not cause any particular damage to Charly.
The Court of Appeal approached the construction of the clause on the basis of the principle that the amount stipulated as damages should be proportionate to the extent of the breaches. It was held that it was not unreasonable to take an overall figure of the kind agreed for the failure to return all or a substantial part of the production parts. In this case the same sum was payable for failure to return even a few of some comparatively unimportant items. The sum was therefore out of all proportion to any loss suffered and was a penalty.
In the Court of Appeal in Jeancharm Limited v Barnet Football Club Limited [2003] EWCA Civ 58 by an agreement dated 7th April 1998 the parties agreed that Jeancharm would be Barnet's suppliers of football kit (shirts for the team, replica kits and the like) for the seasons 1999/2000 and 2000/2001.
The agreement provided that if Barnet was late in paying, they had to pay interest at 5% per week. If Jeancharm were late in delivering, they had to pay 20 pence per garment per day.
The Court of Appeal noted that the parties agreed that the terms dealing with late payment, was a penalty clause and described it as such. They considered that was not conclusive.
Jeancharm invoked its penalty clause, claiming 5% penalty for late payment down to the date of judgment. Barnet said the clause was a penalty clause in law, as well as being stated to be one in the contract, and thus unenforceable. The judge rejected that and upheld the clause. That took Barnet's liability from £5,000 to about £20,000. The 5% per week figure amounted to an annual rate of about 260% percent.
It was held (Mr Justice Jacob) that on any basis, 260% was an extraordinarily large amount to have to pay for the suggested administrative costs, even if the sums involved were relatively small. It was purely a matter of speculation, and the clause went wider than that and covered comparatively large debts too. In this case the bill of £5,000 went to £20,000. It was held that the clause was a penalty clause in the Dunlop sense and unenforceable and the appeal was allowed.
In North Sea Ventilation Limited v Consafe Engineering (UK) Limited [2004] HH Judge Cockroft held that the provision of graduated sums increasing in proportion to the seriousness of the breach was characteristic of a liquidated damages clause which was commonplace in commercial contracts.
In Alfred McAlpine Capital Projects Limited v Tilebox Limited [2005] EWHC 281 (TCC) Mr Justice Jackson considered a contract based on a JCT Form.
On 27th April 2001, Tilebox and McAlpine entered into a written building contract in the JCT Standard Form with Contractor's Design 1998 subject to a number of amendments. The contract sum was £11,573,076. The date for completion was 12th July 2002. Clause 24 of the contract conditions provided that McAlpine should pay liquidated and ascertained damages for delay at the rate specified in appendix 1 to the contract. Appendix 1 to the contract in its amended form provided in relation to clause 24: a rate of £45,000 per week or part thereof. Clause 25 of the contract conditions provided for extensions of time to be granted in certain events.
McAlpine applied to the Court for a declaration that clause 24.2 of the building contract was an unenforceable penalty.
It was held that the losses flowing from delay which were foreseeable on 27th April 2001 fell under three heads
- Diminution of the development completion payment which Tilebox would receive from the funders. It was held that it would have been reasonable in April 2001 to expect the weekly loss attributable to erosion of the development completion payment to be in the region of £30,000. The actual figure may be somewhat higher or it may be somewhat lower. This could not be foretold at the time when the building contract was executed.
- Tilebox's own direct losses. It was held that it would have been reasonable in April 2001 to foresee a weekly loss falling somewhere within the range between £5,000 and £10,000 under this head.
- Tilebox's liability in damages to the funders. It was foreseeable in April 2001 that if McAlpine delayed completion, then Tilebox would be liable to the funders under their contract. Both McAlpine and Tilebox had copies of the provisions. Once credit was given for no longer being required to pay the development completion payment the starting point for assessing damages was the rental income which had been lost. There was no dispute between the parties that it was foreseeable in April 2001 that lost rental income would be somewhere in the region of £45,000 per week.
It was held that Clause 24.2 of the building contract was an entirely reasonable pre-estimate of damages. With Tilebox's own losses and Tilebox's liability in damages to the funders £45,000 per week was too low.
Of particular interest is the approach taken by the Court on the basis that McAlpine did not have a back-to-back liability for the damages for breach of the agreement between the funders and Tilebox resulting from McAlpine’s delay. On this hypothesis, Tilebox's foreseeable losses flowing from delay were only (i) diminution of the development completion payment and (ii) Tilebox's own direct losses.
From the viewpoint of April 2001, it was considered most unlikely, although just conceivable, that the total weekly loss would be as high as £45,000. It was held that clause 24.2 should not be struck down as a penalty, for five reasons which are instructive since they demonstrate the latitude of assessment which the Courts will allow, the relevance of pre-contract conduct and the relevance of the reasonableness of the assessment.
- The figure of £45,000 was at or slightly above the top of the range of possible weekly losses flowing from delay. It was considered that whether the top of the range or the middle of the range of possible future losses was taken as the yardstick, the gap between that yardstick and £45,000 was not nearly wide enough to warrant characterising of the clause as a penalty.
- It was considered that a genuine attempt was made to estimate the losses which would flow from future delay and that perfectly sensibly, a conservative estimate of rental value was taken. The court accepted that if the estimate was substantially wrong, then the genuineness of the efforts could not save the clause. Nevertheless, that was a relevant factor.
- It was considered that the difficulty which was inherent in the exercise of estimating future losses made it particularly sensible in this case for the parties to have agreed upon a weekly figure, by reference to the Dunlop formulation sub-paragraph (d).
- It was observed that the Court was predisposed where possible to uphold contractual terms which fixed the level of damages. This predisposition was somewhat stronger in the present case because the building contract dated 27th April 2001 was a commercial contract made between two parties of comparable bargaining power.
- It was found that during the course of the pre-contract negotiations, the level of liquidated damages was the subject of specific debate. A figure of £45,000 was considered not only by the parties, but also by their legal advisors. It was considered that the fact that clause 24.2 and its appendix survived such scrutiny was further evidence that, as at April 2001, the liquidated damages provision was reasonable.
The Court then examined whether the absence of a limit, or a change to the level of liquidated damages when the development completion payment had been eroded, was fatal. On Tilebox's case the weekly erosion of the development completion payment would come to an end after 43 weeks. On McAlpine's case, such erosion would end very much sooner. After that point in time, Tilebox's losses flowing from delay would reduce to somewhere between £5,000 and £10,000 per week. It was held that this circumstance did not cause clause 24.2 to become a penalty for three reasons.
- It was considered that the precise length of time before this head of loss would end was uncertain. It was, however, foreseeable that this head of loss might continue to run for up to about 40 weeks.
- It was found that at the time of negotiating the contract, both parties took the view that, if there was delay, it would be for substantially less than 40 weeks.
- It was held that against this background, it was perfectly sensible and reasonable for the parties to agree a weekly figure which included allowance for erosion of the development completion payment.
It is difficult to understand this part of the judgment. It appears that the parties had not addressed the loss that might occur after some 40 weeks. On this basis the level of liquidated damages for a period after some 40 weeks would appear to be unreasonable. It may be that the Judge decided that it was reasonable for the Parties not to make allowance in the rate for liquidated damages for a delay beyond the 40 weeks, although the exact words of the judgment do not support that interpretation.
It is suggested that as a matter of practice the limit for the rate of liquidated damages should always be considered to avoid the possibility that the clause may otherwise be struck down as a penalty.
In BFI Group of Companies Ltd -v- DCB Integration Systems Ltd (1987) the arbitrator held that there had been a delay in completion but declined to award liquidated damages on the grounds that the Employer had suffered no resulting loss. His Honour Judge John Davies QC heard the appeal and decided that the liquidated damages clause automatically came into play when the contractor without a contractual justification completed late and the Employer was not required to demonstrate that he had suffered loss. The arbitrator was wrong in law in refusing to award payment of liquidated damages.
In J.F. Finnegan Ltd -v- Community Housing Association (1993), the housing association employed a formula for the purposes of calculating liquidated damages using the estimated cost of the scheme and the lending rate, which resulted in a figure of £2,500 per week. The housing association was reliant upon public funds to finance their projects and a condition of the Housing Association Grant was that there should be a LAD clause in the contract, calculated on the basis of the formula to arrive at the correct weekly damages.
It was held that the figure of £2,500 per week was a genuine attempt by the defendant to estimate in advance the loss it was likely to suffer should the plaintiff fail to complete the works and be in breach of contract. He rejected the plaintiff's argument that the £2,500 was "extravagant and unconscionable". He also found that the use of the formula was justified at the time in which the contract had been entered into.
“Finally, I should say that I have considered the general question of how it can be said that the defendant has made a genuine estimate of its damages when it is required by a third party to put its calculation in a formula over which the defendant had not control? The reality is that the defendant relies upon third parties for its sources of funding. It is not in my judgement unreasonable for a third party to protect their position by requiring the defendant to include in its contracts with others a clause of the nature which has been the subject of this action. The plaintiff's position is safeguarded if the court then proceeds to examine the 'imposed clause' as between the plaintiff and the defendant and consider the question of penalty accordingly.”
In Robophone Facilities Ltd -v- Blank (1966) 1 WLR 1428 Diplock L.J. stated at page 1447:
“The onus of showing that a stipulation is a penalty clause lies upon the party who is sued upon it .....”
Accordingly a contractor challenging the application of a liquidated damages clause as being a penalty is put to proof that his allegation is correct. It is not for the Employer to prove that the liquidated damages amount is a reasonable pre-estimate of loss. This has been confirmed by the Court of Appeal in Jeancharm Limited v Barnet Football Club Limited [2003] EWCA Civ 58.