Most typically, they provide that, where a contractor fails to complete the contract works by the stipulated date, then it shall pay the employer, or allow the employer to deduct, LDs at the given rate per day or week for the period during which the contract works remain incomplete. As such, the primary obligation, to complete the works on time, is replaced by a secondary obligation, to pay the LDs. Such provisions may also be used where certain performance criteria are to be achieved. The advantage of this arrangement is that the contractor has certainty as to the financial exposure it faces for breach of contract, whilst the employer does not have to incur time and expense proving its loss. LDs have been recognised as commercially desirable by the courts in England and Wales, always providing that they do not fall foul of the law on penalties, which provides that the LDs must represent a “genuine covenanted pre-estimate of damage”. This principle was established a century ago, in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co which suggested that an LDs provision would be unenforceable if the amount payable was “extravagant, exorbitant or unconscionable.” This has led to a number of challenges to LDs clauses on the basis that they constituted a penalty. More recently, the lower courts have refined their position in relation to the operation of LDs clauses, with an acknowledgement that in certain circumstances there may be a “commercial justification” for such provisions even where the amount to be paid appears penal. Now, for the first time in a century,
the UK Supreme Court has considered the “penalty rule”. Commenting that the rule is “an ancient, haphazardly constructed edifice which has not weathered well”, on 4 November 2015 the Supreme Court handed down its judgment in relation to two conjoined appeals that turned on the penalty rule, which are summarised below. Background to the Supreme Court appeals In Cavendish Square Holding BV v Talal El Makdessi , Mr Makdessi had entered into an agreement to sell Cavendish a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. Two clauses of the agreement provided that if he breached certain restrictive covenants Mr Makdessi (a) would not be entitled to receive the final two instalments of the sale price (clause 5.1); and (b) may be obliged to sell his remaining shares to Cavendish, at a price that excluded the value of the goodwill of the business (clause 5.6), thus ostensibly well below value. When Mr Makdessi breached those covenants, he argued that the two clauses were penalty clauses, which were unenforceable. At first instance, the Court found against Mr Makdessi, holding that the clauses were not penalties, and were enforceable. Mr Makdessi then appealed, and the Court of Appeal overturned the first instance decision, holding that the clauses were unenforceable penalties. This decision was then appealed to the Supreme Court by Cavendish.
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