Last edited 23 Oct 2020

Penalties in construction

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In construction, the term 'penalty' typically refers to a financial payment imposed in the event of a breach of contract.

In 'Legione v Hateley' [1983], Mason and Deane JJ defined a penalty as follows:

“A penalty, as its name suggests, is in the nature of a punishment for non-observance of a contractual stipulation; it consists of the imposition of an additional or different liability upon breach of the contractual stipulation …”

However, 'penal' clauses, ie those that impose a punishment may not enforceable. Until recently, it was considered that they must be based on a genuine calculation of actual damages incurred. In effect therefore 'penalties' were not allowed, albeit the phrase was still commonly used to refer to the payment of damages or some other liability imposed upon breach of a contractual stipulation.

For example, liquidated and ascertained damages (LADs) are common in construction contracts, generally relating to the failure of the contractor to complete the construction works before the date required by the contract. However, they are generally based on a genuine calculation of damages, and if they are not, or if they are exorbitant, they may be considered a penalty by the courts and therefore may be unenforceable.

For more information see: Liquidated and ascertained damages.

This precedent was set by Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd, in which a contractual provision was considered to be a penalty if it was penal rather than a pre-estimate of loss. This determination is often made based on the terms and inherent circumstances of each particular contract, judged at the time of making the contract, not at the time of the breach.

However, in the case of 'Cavendish Square Holding BV v Talal El Makdessi (El Makdessi) and ParkingEye Ltd v Beavis' [2015], the Supreme Court re-considered the long-established principles underlying contractual penalty clauses. It held that the 'Dunlop rule' had been too rigidly applied, particularly where the inclusion of a penalty clause may have some clear justification, commercial or otherwise.

Lord Hodge stated that the "correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract".

The new test set out by the Supreme Court recognises that the contractual party may have a legitimate interest which can be protected by a contractual penalty, and this interest need not be a genuine pre-estimate of loss. If that party is able to demonstrate that the penalty clause is being used to protect that legitimate interest, and it is not 'exorbitant or unconscionable', then they do not have to suffer a loss, and the predominant purpose of such a clause can be deter the other party from a certain breach of contract.

Examples of other penalties relevant to construction, not strictly related to breaches of contract, include:

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