Liquidated Damages and Service Credits - maximising enforceability

For the first time in a century, the Supreme Court has provided a detailed review of the law on contractual penalties. But what does it mean for commercial contracts? Should you change approach for future contracts, should existing contracts be reviewed? In summary we will not be changing our approach to contractual penalties. In this alert we explain why, and what we think is the right approach.

Background

The two disputes that were considered, Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis, could not be more different.

In Parking Eye Mr Beavis claimed that the £85 charge for outstaying the two hours free parking at a shopping centre was unenforceable, because it was a penalty and also a breach of consumer law.

In Makdessi, Mr Makdessi sold his business and then breached his restrictive covenant. He claimed the financial consequences (in summary a reduced payment for the purchase of his business) were unenforceable as penalties.

Although very different circumstances both relate to a breach of contract leading to a defined financial consequence. This is why this judgment is relevant to liquidated damages and service credit regimes.

In both cases the court confirmed the payments were enforceable. The court confirmed that a "penalty" is potentially unenforceable, but that neither situation led to the contractual arrangement being unenforceable.

Is a penalty unenforceable? And if so what is a penalty?

In a 123-page judgment, the court went into considerable detail, tracing the law on penalties from the 16^th Century. It concluded that:

• Courts should be wary of intervening where the parties have agreed specific arrangements.
• "Penalties" are potentially unenforceable.
• The key reference point is whether the payment is "extravagant and unconscionable" or "penal" or "out of all proportion to any legitimate interest". If it is, it is probably a penalty and therefore unenforceable.
• If the payment is a genuine pre-estimate of loss then it is not a penalty.
• But just because a payment is not a genuine pre-estimate of loss does not make it necessarily a penalty. If the party who will receive payment has a commercially justifiable interest then it is not a penalty.
• Just because a payment is intended to be a deterrent does not automatically make it an unenforceable penalty. If the party who will receive payment has a commercially justifiable interest then it is not a penalty.

In addition there is suggestion in the judgment that a "primary" obligation can never be a penalty - only a "secondary" obligation can be a penalty. "Primary" means a primary obligation to pay, for example a "take or pay" obligation (where a customer is obliged to pay a fixed sum regardless of whether or not it requires the relevant goods/services) is typically a primary obligation.

A liquidated damages or service credit regime, where the payment of the liquidated damages or services credit are secondary to the main payment mechanism, is typically a secondary obligation. However there is some dissent within the judgment of whether it is correct to distinguish between primary and secondary obligations, and therefore contract drafters should be wary of relying on this distinction.

This means that many liquidated damages or service credit regimes will be enforceable as:

• The customer will have a commercially justifiable interest.
• In the context of that commercially justifiable interest typical liquidated damages and service credit regimes are unlikely to be "extravagant and unconscionable" or disproportionate.

In the past some contract drafters have agonised over whether a service credit/liquidated damages regime is enforceable, worrying that they may not be "genuine pre-estimate of loss" and their deterrent element made them penalties. This judgment means there is less need for such agonising.

Examples to consider

Example 1 (inspired by Medirest^[1])

This is a large, high-value, long-term, complex catering outsourcing contract at a hospital. There is in place a complex service credit regime where points accrued for breaches of the specification are turned at intervals into service credits, which are deducted from the main payment. Out of date sachets of ketchup in the ward kitchen accrue £46,000 in accrued service credits.

The purpose of the service credit regime is to deter breach by the caterer and motivate good performance. The service credit regime may result in sums being payable in excess of the hospital's actual proven loss. The hospital has a commercial interest in motivating good performance by the caterer to achieve a clean, safe hospital with good catering.

So long as the service credit regime is not "extravagant and unconscionable" it is likely to be enforceable.

Example 2 (inspired by Dunlop^[2])

A manufacturer has a network of international distributors, with a similar agreement with each distributor. The agreement has a liquidated damages regime should the distributor fail to comply with certain obligations.

The purpose of the liquidated damages regime is to deter breach by the distributor and motivate good performance. The liquidated damages regime may result in sums being payable in excess of the manufacturers actual proven loss. The commercial interest of the manufacturer is maintaining a consistent web of distributors around the world.

So long as the liquidated damages regime is not "extravagant and unconscionable" (and so long as competition law is complied with) the liquidated damages regime is likely to be enforceable.

Example 3 (inspired by Clydebank^[3])

Manufacturer contracts to supply capital equipment by a certain date and, if it delivers late, to pay a daily sum in liquidated damages. The liquidated damages are capped at a fixed amount (which is less than the value of the equipment) typical of capex equipment supply arrangements.

The purpose of the liquidated damages regime is to deter breach by the manufacturer and motivate delivery on time. The liquidated damages regime may result in sums being payable in excess of the customer's actual proven loss. The customer plainly has a good commercial interest in promoting on time delivery.

So long as the liquidated damages regime is not "extravagant and unconscionable" it is likely to be enforceable.

Flowchart - is my obligation an enforcable penalty?

Follow this flowchart to help work out if your obligation is an enforceable penalty or not.

Practical drafting tips

• Ensure it is clear what the trigger is and the consequences - how much is paid and when?
• Avoid the word "penalty".
• Is the financial consequence a "genuine pre-estimate of loss"? If so:
  • keep a record of why the beneficiary thinks it is a genuine pre-estimate of loss.
  • state in the clause that it is a genuine pre-estimate of loss.
  • in a complex or unusual contract consider explaining why it is a genuine pre-estimate of loss.
• Consider what the beneficiary's commercially justifiable interest is in the arrangement. If it's not immediately obvious:
  • Keep a record of what the beneficiary considered to be its commercially justifiable interest.
  • Explain in the contract the beneficiary's commercially justifiable interest.
• To maximise enforceability, consider articulating the obligation as a primary obligation. This would be done by emphasising that the obligation is core to the contract and seek to tie it to the primary payment obligation. However, be aware that it is not clear whether or not the law on penalties applies to a primary obligation.
• Consider drafting positively rather than negatively. For example "If you deliver by1 May then we will pay you a bonus of X" may be better than "If you fail to deliver by 1 May then we will deduct X as liquidated damages". However, you will want to weigh up the legal subtleties against what is actually best to promote performance

Useful resources

• If you are especially interested in what this means for restrictive covenants in contracts to sell businesses then see our alert specific to those issues.
• Our construction experts have produced an alert focusing on the implications for the construction sector.
• You can also read the case at the UK's Supreme Court's website.

Footnotes

[1] Mid Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd (t/a Medirest) [2013] EWCA Civ 200
[2] Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC79
[3] Clydebank Engineering and Shipbuilding Co v Castaneda and Others [1904-07] All ER Rep 251