If the cap fits

Stair was fond of penalties. In his 1681 contract for the printing of the Institutions he insisted that the printer keep copies of the treatise under lock and key until all copies were printed under “the pain” of £100 Scots for each copy found out of the printer’s custody. The printer was bound to deliver 12 leather copies, half of them gilded, to the author “under the pain of £40 Scots money as the liquidate price thereof by consent”. As if this was not enough, both parties had to perform the contract “under the pain of 1000 merks of Scots money, by and attour [in addition to] performance of the premises”.

Whether such clauses would have survived scrutiny of the courts we shall never know. Stair wrote that it was part of the nobile officium of the Court of Session to modify penalties in contracts where they were exorbitant, even if they were referred to as liquidate expenses and agreed to by the parties, and to substitute the real expense and damage of the parties. Whilst the jurisdiction may now have changed, the underlying prohibition of the recovery of exorbitant sums remains.

Liquidate and ascertained damages (or “LADs” for shorthand) are merely sums payable by the defaulting party in the event of its breach of contract. If they are LADs, they are enforceable and the sum stipulated for recoverable. By contrast if they are penalties, the sum is not recoverable and the innocent party is left to prove its true loss. Such provisions were common in bonds, charterparties and indentures for apprentices. They even appeared in agricultural tenancies where a penalty was payable for “miscropping”, i.e. sowing a crop out of rotation. Nowadays such clauses are often inserted in process engineering or power station contracts, where the achievement of a certain output is often subject to LADs, but they appear most commonly in construction projects.

Distinguishing features

Commercially such clauses are extremely important because they almost always provide that the employer may retain or set off the LADs against sums otherwise due to the contractor. It is evident that this gives the contractor every incentive to attack the LAD provision as a penalty. What are the rules distinguishing a liquidate sum from a penalty?

They derive from two House of Lords authorities, Clydebank Engineering [1905] AC 6 and Dunlop Pneumatic Tyre Co [1915] AC 79, one a Scottish case and the other an English case but applying Scottish legal principles. Both were decided at the beginning of the 20th century. In summary:

• The use of the word “penalty” or “liquidate damages” in a contract is not conclusive.
• The essence of a penalty is the payment of money in terrorem the offending party. The essence of a liquidate sum is that it is a genuine pre-estimate of loss. This has to be judged at the date of the contract, not as at the time of breach.
• It will be a penalty if the sum stipulated is extravagant and unconscionable in amount by comparison with the greatest loss that might conceivably have flowed from the breach.
• It will be presumed to be a penalty where the sum is payable in the event of several different breaches, some of which may cause little loss.
• The fact that it is difficult or impossible to make a precise pre-estimate of loss does not prevent a sum being a genuine pre-estimate; indeed this is precisely the sort of situation in which the sum stipulated was the true bargain between the parties.

Some of the language used in these cases is somewhat anachronistic. Thus the present approach is not to ask whether the sum was stipulated in terrorem but whether the predominant function of the clause was to deter a party breaching the contract (a penalty) or to compensate the innocent party for breach (a liquidate sum).

In practice courts generally uphold LADs. Indeed you would be hard pressed to find modern cases striking them down. Thus a genuine pre-estimate of loss does not have to be right to be reasonable, nor does the test turn on the genuineness or honesty of the party making the estimate. Similarly even if the sum might in certain circumstances be greater than the likely loss, the specified sum will be recoverable unless it can be said to be extravagant by comparison to the range of losses that it could reasonably have been anticipated it would cover at the date of the contract.

Applying a cap?

Whilst these tests may assist in striking down extravagant LADs, what if the sum stipulated is less than the likely loss or, as in two reported cases, the LADs are specified as “nil”? Such a provision could mean that the parties had agreed that in the event of delay the losses were not to be dealt with by way of LADs at all, leaving the innocent party to prove its loss. Alternatively it could simply mean that no damages were to be payable in the event of delayed completion. In the Scottish case Lord Prosser did not have to decide the point but thought there was an ambiguity to be investigated (Stanley Miller 1988 SLT 514). In the English case, decided at about the same time, the Court of Appeal held that it meant the parties had agreed that no damages for delay were to be payable (Temloc v Errill Properties (1987) 39 BLR 30).

Where the LADs are held to be penal, does the stipulated sum act as an upper limit of recovery? A contractor would clearly think twice about running the penalty argument if it were to find that the employer could recover more than the stipulated sum. In English law there is a line of authority derived from charterparty cases which suggests that the claimant may have a choice either to sue for LADs or to ignore the clause and claim general damages without limitation. In Dingwall v Burnett 1912 SC 1097 the defender let the St George Hotel, Dunbar to the pursuer on terms that the pursuer was to take over the furniture and fittings and stock of liquors. Further detailed terms included provisions in the event that the licence could not be transferred to the pursuer. The agreement also provided for the payment of £50 if either party failed to perform the obligations set out. The pursuer refused to perform its part of the bargain and the defender claimed damages of over £300. The Inner House held that the clause in question was penal since it specified a single sum payable upon a breach by either party, the consequences of which could have been either no or substantial loss. The suggestion that the defender was limited to recovering £50 was described as a “somewhat startling proposition”. However startling this suggestion may have been in 1912, it is thought that the case can probably be distinguished on its facts and that nowadays a clause struck down on the basis of being penal would act as the upper limit of recovery.

In practice LADs in construction contracts are inserted by employers on a “take it or leave it” basis, with little or no information provided as to how the sum in question has been calculated. The contractor therefore usually cannot know whether the sum is a genuine pre-estimate of loss and its bargaining power on this aspect is often limited. At most it can price the risk, but more usually a contractor will assume that it can complete in time or obtain the requisite extension of time or, possibly, attack the LADs. Very few contractors, if any, would agree with the suggestion that a liquidated sum is to be welcomed on the basis that it provides certainty. Most, if not all, contractors when faced with a claim for LADs would wish to force the employer to prove its loss.

It is of course important to identify the scope of the LAD clause. Does it cover the breach in question or is the employer free to recover unliquidated damages? Thus a LAD clause which provides for payment on failure to complete by a specified date will encompass all claims for breach which result in delay, whether the delay is caused by lack of resources or remedying defective work. By comparison an employer under a contract which required all coal from an opencast mine to be extracted was not limited to the specified LADs for failure to complete by the due date, or by a further clause which specified LADs for a failure to produce minimum quantities of gigajoules, and could accordingly claim such damages as it could prove (Scottish Coal Co v Kier Construction [2005] CSOH 74).

Stair would undoubtedly have recognised the situations described above as familiar territory, and judging by his publishing contract would probably have been as reluctant as the courts have been to strike down such clauses.

Stephen Furst QC is a barrister at Keating Chambers and joint editor of Keating on Construction Contracts

Unique status

In many ways liquidated damages clauses are unique. Subject to statute, parties are by and large free to agree to anything they wish, but in this one respect the courts assume a jurisdiction to strike down such clauses, even if they have been freely agreed to. Since this power only arises in cases where a sum is payable on breach, it is not too difficult to avoid the scrutiny of the courts by careful draftsmanship. Thus a contract stipulating payment of £500 per day by a contractor if he fails to complete by 1 January might be attacked as a penalty and therefore unenforceable. By contrast, a contract which reduced payments to the contractor in the event of completion after 1 January probably would not be susceptible to attack. Such drafting techniques were adopted by the banks, and thus the courts were unable to consider whether the fees and other sums payable by their customers on unauthorised overdrafts were penal. In other words these “penal” sums were not payable on breach but as a term of the contract between bank and customer, and were therefore not subject to examination by the courts, at least under this jurisdiction.