Last edited 10 Oct 2018

Penalty

In construction, the term 'penalty' typically refers to 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 …”

The parties to a contract may agree on the amount to be awarded in the event of a breach of contract. Such payments may be referred to as liquidated and ascertained damages (LADs) and are commonplace in construction contracts, usually related to failure to complete the construction works before the date required by the contract.

As LADs are not a penalty, they must have been based on a genuine calculation of damages when they were set. If they are not genuine, or are exorbitant, they may be considered a penalty by the courts and therefore may be unenforceable (see Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd).

The rule set out in 'Dunlop' was that a contractual provision is considered to be a penalty if it is penal rather than a pre-estimate of loss. These are not natural opposites or mutually exclusive categories. A damages clause may be neither or both. It is often decided upon by the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as 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 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 often 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:

  • If landlords fail to carry out appropriate checks and rent a property to someone who is not allowed to stay in the UK, they could face a penalty of up to £3,000 per tenant.
  • Local authorities can serve a legal notice on the person responsible for noise. If the noise problem persists they may be given a fixed penalty notice or taken to court and fined up to £5,000.
  • Renting out a property that does not comply with the minimum energy efficiency standards might incur a penalty of up to £4,000 for domestic properties and up to £150,000 for non-domestic properties.

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