BULLETIN: Construction law update - July 2016

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A construction law update for June 2016 from Blake Morgan.

Penalty clauses - where are they now? 

Cases: Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67

The essence of a penalty is the exertion of undue pressure on a party to perform a contractual obligation, with the threat of a fine or punishment for failure to perform. The courts will not enforce a penalty against the defaulting party.

Lord Dunedin's judgment in Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79 set out a number of principles to help govern the distinction between liquidated damages and a penalty.

Lord Dunedin's principles provide that:

  • The terminology used by the parties is not conclusive. Calling damages a "penalty" does not necessarily render them so, and vice versa.
  • The essence of a liquidated damages clause is a genuine pre-estimate of damage. A penalty requires the party in breach to make a payment in terrorem (that is, its purpose is to intimidate).
  • Whether a clause represents liquidated damages or a penalty will be determined on the basis of the circumstances of the contract at the time it was entered into and not at the time of the breach.

Lord Dunedin set out a number of tests, or "expressions", which, if applicable, may assist in determining the true nature of a stipulated sum. In summary:

  • A sum will be a penalty if it is extravagant and unconscionable compared to the greatest loss that would have resulted from the breach.
  • Where a breach is a failure to pay a sum of money that is less than the stipulated sum, the stipulated sum will be a penalty.
  • If a single stipulated sum applies to several different kinds of breaches, some of which may have significant financial implications and others very minor financial implications, this creates a presumption (but no more) that the sum represents a penalty.
  • A sum is not a penalty simply because an accurate pre-estimate of the likely loss is almost impossible. In fact, liquidated damages may be most useful to the parties in such situations. Lord Dunedin thought that the figure stipulated in a contract in such circumstances probably would represent a true bargain between the parties.

However, in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67 the Supreme Court cautioned that:

"Lord Dunedin’s speech in Dunlop achieved the status of a quasi-statutory code in the subsequent case-law. Some of the many decisions on the validity of damages clauses are little more than a detailed exegesis or application of his four tests with a view to discovering whether the clause in issue can be brought within one or more of them. In our view, this is unfortunate. In the first place, Lord Dunedin proposed his four tests not as rules but only as considerations which might prove helpful or even conclusive 'if applicable to the case under consideration'. He did not suggest that they were applicable to every case in which the law of penalties was engaged."

In Cavendish, the Supreme Court restated the applicable legal principles for deciding whether a clause is penal. The principles set out by the Supreme Court are not entirely novel. They rely on principles of extravagance and unconscionability that can be traced back to earlier authority, including Dunlop. In Cavendish, the Court held (at paragraph 32):

"The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin’s four tests [in Dunlop] would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations."

The Supreme Court noted that previous authorities, including those that applied a "commercial justification test", showed that an innocent party's legitimate interest is not confined to compensation:

"A damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach."

Additionally, the Supreme Court confirmed that a slavish adherence to the principles established in Dunlop was "artificial":

"In our opinion, the law relating to penalties has become the prisoner of artificial categorisation, itself the result of unsatisfactory distinctions: between a penalty and genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent. These distinctions originate in an over-literal reading of Lord Dunedin’s four tests and a tendency to treat them as almost immutable rules of general application which exhaust the field."

It remains true that:

  • The courts of England and Wales will not treat liquidated damages that represent a genuine pre-estimate of loss as an unenforceable penalty. In Cavendish, the Supreme Court stated that Lord Dunedin's tests in Dunlop "...are a useful tool for deciding whether these expressions can properly be applied to simple damages clauses in standard contracts." Lord Dunedin's fourth "expression" refers to the difficulty of precisely pre-estimating a loss.
  • Parties to construction and engineering projects usually agree liquidated damages that apply to specific breaches only, where the damage can be quantified in pure monetary terms. It is too arbitrary to agree one figure as a "catch all" estimate of loss for a breach of any clause of the contract, where the seriousness and financial consequences of breaches may vary significantly. For example, an engineering contract may include liquidated damages for both late completion and failure to meet the required performance standard. These events should be subject to separate liquidated damages clauses and separate rates or formulae for the calculation of any liquidated damages due. Combining multiple events into a single liquidated damages clause with a single financial consequence risks conflict with Lord Dunedin's third "expression" in Dunlop.

Difficulties may arise where the relevant clause is neither a clear penalty, nor based (or solely based) on a genuine pre-estimate of loss. It is not accurate to assume that a clause that is not a genuine pre-estimate is automatically unenforceable. If;

  • the damages fixed as compensation do not solely reflect the likely loss to the innocent party, but have some commercial justification and are not merely a deterrent; and
  • the clause has been agreed following an arms' length commercial negotiation of the type common in the construction and engineering industries,

it may be difficult to establish that the relevant clause is a penalty.

If a liquidated damages clause in a contract requires payment for breach of a sum that a defaulting party can show is "out of all proportion" to the other party's "legitimate interest", the defaulting party may seek to challenge the clause.

Keep it down! landlord's covenant for quiet enjoyment means construction work must cause minimal disturbance to tenants.

Case: Timothy Taylor Ltd v Mayfair House Corporation and another [2016] EWHC 1075 (Ch)  

A landlord is under an implied obligation to afford its tenant "quiet enjoyment" of the demised property. This implied obligation is usually expressly stated in the lease. The covenant for quiet enjoyment dovetails with a landlord's implied obligation not to derogate from its grant (i.e. by its action prevent the tenant from enjoying the demised premises).

On a number of occasions, the Courts have been required to consider the interrelationship between the implied covenants for quiet enjoyment and non-derogation from grant, and the landlord's express (or implied) right to carry out repairs or alteration works to the building of which the demised premises form part.

In Lechouritis v Goldmile Properties Ltd [2003] EWCA Civ 49, the Court of Appeal upheld the District Judge's finding that a landlord will not be in breach of the covenant for quiet enjoyment if it has taken all reasonable steps to minimise the impact of the works on the tenant. The Court of Appeal held:

"…the obligation to keep the building in repair has to coexist with the tenant's entitlement to quiet enjoyment of the premises he is paying rent for. This by itself points towards a threshold, for disturbance by repairs, of all reasonable precautions rather than all possible precautions."

In Century Projects Limited v Almacantar (Centre Point) Limited [2014] EWHC 394 the Court held

“…where a landlord has let premises for a particular purpose and the lease contains both a covenant for quiet enjoyment and an obligation or right on the landlord to do repairs, neither provision trumps the other. On the contrary, they have to be made to fit together. The landlord cannot say that as the tenant took the demise subject to his repairing obligation, the tenant has to put up with the landlord's works, however unreasonably they are carried out. But, equally, the tenant cannot say that having given the covenant for quiet enjoyment, the landlord cannot carry out any work unless it is shown to cause the least possible interference with the tenant’s business. Both positions are too extreme. The way the two provisions fit together is that the landlord can carry out work provided he acts reasonably in the exercise of his right.”

In the instant case, the tenant operated a high class art gallery in Mayfair under a 20 year lease at a rent of £530,000 per year. The lease expressly reserved the right for the landlord to alter or rebuild the building of which the demised premises formed part.

In 2013, the landlord commenced major construction works to rebuild the interior of the building to create new apartments to let. The tenant accepted that the landlord was entitled to carry out the works and that some degree of disruption would inevitably result. However, the tenant contended that the landlord had failed to take all reasonable steps to minimise disturbance arising from the works and, consequently, was in breach of its covenant for quiet enjoyment.

The Court held that, when considering whether or not a landlord has taken all reasonable steps to minimise the impact of construction works on a tenant, regard should be had to the following matters:

  • What knowledge or notice the tenant had of the works intended to be carried out by the landlord at the commencement of the lease.
  • Any offer of financial compensation made by the landlord to the tenant for the disturbance caused by the works.
  • Whether the works were being carried out for the personal benefit of the landlord or for the benefit of all the tenants in the building.

The Court held that the landlord was acting unreasonably in the exercise of its right to build and was in breach of its covenant for quiet enjoyment and in derogation from grant for the following reasons:

  • The Court noted that the most that the tenant was told at the time of the lease was that the landlord had a general intention to carry out some works to the building at some stage. The tenant was not told about any specific works, or that they would be so extensive.
  • Whilst a landlord is under no obligation to offer any form of discount, such an offer can affect "the overall reasonableness" of the landlord's works.  On the evidence, there was no discount made in the initial (high) rent or on rent review to take account of the proposed works and a refusal by the landlord to discuss compensation. The Court held that the landlord's "point blank" refusal to offer any form of discount "raises the bar as to what reasonableness requires".
  • In this case (unlike in Goldmile or Century Projects), the landlord was exercising its right to do works entirely for its own purposes and the works conferred little or no benefit on the tenant.
  • The Court noted that it was dealing with premises let for use as a high class art gallery for a high rent. As such, the landlord had to exercise its right to build with "a particular regard", so far as reasonably possible, to the need of the tenant "to keep the Gallery running and with as little disturbance to it and its customers and staff as possible".
  • The way the scaffolding was designed and erected paid little or no regard to the interests of the tenant and was entirely unreasonable: "…the scaffolding…caused the Gallery to be "enwrapped"…in the whole Building, giving the impression to outsiders that the Gallery had entirely disappeared and was now part of what was a building site".
  • The landlord had failed to liaise appropriately with the tenant as to the likely duration of the works, the noise levels likely to be experienced and how to mitigate the impact of noise. It was incumbent upon the landlord, when planning and undertaking works of this magnitude, to liaise properly and to agree the method by which the work could be carried out with the minimum of disturbance.

The Court held that the tenant was entitled to damages for breach of the covenant for quiet enjoyment and non-derogation from grant assessed at 20% of the rent payable under the terms of the lease from 14th August 2014 (the date the scaffolding started to be erected) until completion of the works.

Jessica Tresham elected to society of construction law council

Team member Jessica Tresham has been elected to the Council of the Society of Construction Law (SCL).

Jess's election means that she will serve an initial term of three years to the SCL's Council comprising 20 pre-eminent construction practitioners.

It follows on from Jess’s efforts working as a Regional Co-ordinator for the past four and a half years, organising and attending construction industry events.  Election to the Council itself was a little more formal in process.  Once identified as a contender, Jess was invited to submit a written paper and participate at hustings before a vote by the society's members.  

Jess hopes to become involved in the SCL's bursary and funding of education initiatives with a view to promoting  a "grass-roots" bursary to assist young people from less privileged backgrounds.

The SCL was formed in 1980 and has circa. 2,400 members in the UK and overseas.  Membership is drawn from all sectors of the construction industry including architects, engineers, surveyors, contractors, developers, arbitrators, barristers and, of course, solicitors.

Regular meetings and educational talks as well as lunches and dinners are organised by the SCL in London and the regions. Jess is organising the SCL's inaugural lunch planned for Southampton and this will be held in October 2016.

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