Author: Melissa Perkin 

Liquidated damages clauses, a common feature of construction contracts, stipulate the amount of money payable as damages for loss caused by a breach of contract, irrespective of the actual loss suffered.

A recent United Kingdom decision of the Technology and Construction Court (TCC) in Eco World – Ballymore Embassy Gardens Company Ltd v Dobler UK Ltd[1] (Eco World v Dobler) has enforced a liquidated damages clause which did not allow for a proportionate reduction in liquidated damages following partial possession of completed sections of a development. The court rejected arguments that the clause was a penalty and considered a number of alternative arguments, including whether there was an obligation to consider levying a reduced amount of liquidated damages and whether an otherwise invalid liquidated damages clause could nevertheless operate as a cap on liability.

We have a look at the Eco World v Dobler decision and then look at the approach taken by the New Zealand Supreme Court in the leading case, 127 Hobson Street Ltd v Honey Bees Preschool Ltd (Honey Bees)[2].

 

The Facts in Eco World v Dobler

Eco World engaged Dobler to carry out the design, supply and installation of façade and glazing works for a residential development. There was a delay of several months between the contractual date for completion and when practical completion was certified.

After certification of practical completion, a dispute arose as to the level of liquidated damages Eco World was entitled to recover for Dobler’s delay. After an initial grace period after the Date for Completion, the contract provided for a single weekly sum as follows:

“Liquidated damages will apply thereafter at the rate of £25,000 per week (or pro rata for part of a week) up to an aggregate maximum of 7% of the final Trade Contract Sum…”

The contract also required Eco World to notify that it required Dobler to pay liquidated damages at the rate stated in the contract “or lesser rate stated in the notice”.

Eco World commenced proceedings in the TCC seeking declarations as to:

(1) the validity and/or enforceability of the liquidated damages clause in circumstances where Eco World had taken possession of some of the completed sections of the development and there was no mechanism for a proportionate reduction in the amount of the damages; and

(2) if the liquidated damages clause was void, whether it nonetheless imposed a cap on the level of general damages Eco World was entitled to claim for delay.

Did partial possession make the liquidated damages clause unenforceable?

The TCC re-sounded the trite principles of interpretation in conjunction with a liquidated damages clause, accounting for:

  • its natural and ordinary meaning,
  • other relevant contractual provisions,
  • the overall purpose of the clause, and contract,
  • the circumstances known to or assumed by the parties at the date of the contract, and
  • commercial common sense: Arnold v Britton[3]. 

The TCC further observed that the liquidated damages clause, as drafted, contemplated a failure to meet:

(a) contractual dates for completion of sections of works; and/or

(b) the contractual date for completion of the whole of the works – but not for an alternative rate of liquidated damages applicable to any late completion affecting part of the works.

Even though the liquidated damages clause did not provide a mechanism for reduction in liquidated damages on partial possession by Eco World, there was no uncertainty as to the amounts payable. The full amount of liquidated damages was payable for each week of delay regardless of any partial possession taken by Eco World.

The TCC then considered whether such a clause offended the rule against penalties[4]. That required the court to consider whether the clause was “extravagant, exorbitant or unconscionable” and whether it was “out of all proportion to” Eco World’s legitimate interest in securing timely completion of the works. Applying this test, the TCC determined that the provision did not amount to a penalty for the following reasons:

  • The clause was fully negotiated by commercial parties and their lawyers, meaning the court should be slow to intervene in commercial freedoms, especially those which govern how risk of delay in works completion is managed (see also Cavendish Square).
  • Eco World had a legitimate interest in enforcing completion of the works as a whole by the contractual completion date as late completion would have an adverse impact on the rest of the project by delaying following trades, exposing Eco World to liability and putting at risk prospective sales of the apartments.
  • Alternative quantification of Eco World’s damages would be difficult, particularly following partial possession. Different combinations of partially incomplete blocks could result in a wide range of loss scenarios. Stipulating a single rate for all scenarios avoided these complexities.
  • the level of damages was not shown in evidence to be unreasonable or disproportionate to the likely loss caused by late completion.

Did Eco World have an obligation to reduce the rate of liquidated damages?

The TCC rejected Dobler’s contentions that there was a contractual mechanism which allowed Eco World to stipulate a “lesser rate” of liquidated damages, finding that the ability of Eco World to levy a reduced amount of liquidated damages was an absolute contractual right, not one conferring a discretion with implied limitations.

Did the liquidated damages clause set a cap on liability even if penal?

Despite the decision in Cavendish Square providing support for the view that general damages should not be limited to the amount of any liquidated damages found to be unenforceable, the TCC considered the clause in this case had two parts, firstly containing a weekly rate for liquidated damages but also stipulating an overall cap on liability for delay. Were the rate of liquidated damages to be struck down due to the rule against penalties, the overall cap on liability could nonetheless be given effect to.

What is the approach taken in New Zealand?

The Honey Bees case concerned a commercial lease entered into between Honey Bees Preschool Ltd and 127 Hobson Street Ltd (127 Hobson) and the enforceability of a provision that provided that, if a lift was not installed by 127 Hobson within two years and seven months, 127 Hobson would indemnify Honey Bees for all obligations under the lease until its expiry.

The lift was not installed in time and Honey Bees Preschool Ltd sought to enforce the indemnity. 127 Hobson countered that the indemnity clause was an unenforceable penalty and should be disregarded.

Both the High Court and Court of Appeal found the indemnity clause lawful and enforceable.

The Supreme Court unanimously dismissed the appeal finding that the obligation to indemnify did not breach the rule against penalties.

Clarifying the test to be applied in New Zealand, the Supreme Court held:

“A clause stipulating a consequence for breach of a term of the contract will be an unenforceable penalty if the consequence is out of all proportion to the legitimate interests of the innocent party in performance of the primary obligation…A consequence will be out of all proportion if the consequence can fairly be described as exorbitant when compared with those legitimate interests.”

The Supreme Court confirmed that a consideration of whether a clause is a penalty is an objective assessment, notionally undertaken at the time of contract formation. Further, that a legitimate interest may extend beyond the harm caused by the breach as measured by a conventional assessment of contractual damages.

The Supreme Court was satisfied that the consequences were not out of all proportion to the legitimate interests of Honey Bees in performance of the obligation to install the lift. Operating a business on the premises which was supported by two lifts and the protection of the future growth prospects of the business was in Honey Bees’ legitimate interest. The Court considered that the “all or nothing” nature of the obligation to install the second lift was relevant to the assessment of whether the consequences contracted for was out of proportion to Honey Bees’ interest in performance. The Supreme Court held that the consequences were not exorbitant in the overall circumstances, including the fact that 127 Hobson was given a generous amount of time to install the lift.

 

Conclusions and implications

The Eco World decision provides an interesting insight into how the United Kingdom court’s approach to the proper interpretation of liquidated damages clauses in application of the Cavendish Square principles together with the familiar rules which secure commercial freedom in negotiating and formulating certain contractual terms, which together, reflect the functionality of such clauses for major construction contracts.

In New Zealand, the Honey Bees case confirms that the primary test for establishing whether a clause amounts to a penalty is the disproportionality test, with the bar being whether the consequence is “out of all proportion” to the legitimate interests of the innocent party in performance of the primary obligation. The bar will be met if the consequence can fairly be described as “exorbitant” when compared with the legitimate interests protected. The disproportionality test gives greater credence to freedom of contract and the enforcement of bargains made by agreement between commercial parties. On this basis, in New Zealand the possibility of a liquidated damages clause being rendered unenforceable as a penalty is limited.

 

[1] Eco World – Ballymore Embassy Gardens Company Limited v Dobler UK Limited [2021] EWHC 2207 (TCC).

[2] 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2020] NZSC 53.

[3] Arnold v Britton [2015] UKSC 36; [2015] AC 1619, per Lord Neuberger (at [15]–[23]).

[4] Most recently discussed by the Supreme Court in Cavendish Square Holding BV v Makdessi [2015] UKSC 67; [2016] AC 1172 (at [31]–[35]) (Cavendish Square).

 

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