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Liquidated damages seen as penalties

Construction and engineering contracts usually include provision for the payment of fixed sums (known as liquidated damages) by the contractor in the event that the works are delayed for reasons which do not entitle the contractor to an extension of time.

However, the courts will not enforce penalty clauses and contractors faced with substantial liquidated damages have often sought to argue that provisions in their contracts are nothing more than penalties.

Unfortunately for contractors, the courts have taken a restrictive view and there are few examples of successful challenges.

The classic articulation of a penalty clause, as opposed to an enforceable liquidated damages provision, came in Lord Dunedin’s Judgment in the House of Lords decision in Dunlop Pneumatic Tyre Co Ltd v New Garage (1915).

The Judge stated: “The essence of a penalty is a payment of money stipulated as in terrorem [ie, intended to frighten] of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage…”

In 2005, Alfred McAlpine sought a declaration from the Court that a liquidated damages provision was not a genuine pre-estimate of the developer’s likely loss. In that case, the developer Tilebox sought to deduct £45,000 per week from Alfred McAlipine. The judge accepted that it was unlikely that Tilebox’s loss would amount to that figure.

However, the judge found that the clause was enforceable, stating that the gap between the contractual rate for liquidated damages and the likely weekly loss “was not nearly wide enough to warrant characterising this clause as a penalty”.

The judge laid down important guidance for those considering challenging a liquidated damages clause. He said that “a pre-estimate of damage does not have to be right in order to be reasonable. There must be a substantial discrepancy between the level of damages in the contract and the level of damages which is likely to be suffered…”

Challenging a liquidated damages provision may well prove difficult. Those tendering for work on contracts which include provisions for the deduction of LAD’s need to consider the risk - and price the work accordingly.

Vijay Bange is a partner at law firm Trowers & Hamlins