WIN Wise: Liquidated damages for delay in tech disputes

The current COVID-19 pandemic is wreaking havoc on businesses and their operations across sectors and geographies. The unprecedented spread of the virus has had, and will continue to have, a profound impact upon both suppliers and customers in delivering technology projects on time and to budget.

The implications of COVID-19 do not necessarily have to lead to the termination of a technology project. Instead, the inevitable delays to contractual milestones and disruption to parties' supply chains can be managed by other mechanisms built into the parties' agreement. While each supply agreement will differ in scope and substance, a common theme that emerges is provision for liquidated damages to be paid to the customer when a project is delayed.

It is a well-known principle that a liquidated damages clause is enforceable provided that it is not penal. By contrast, a provision which operates as a penalty (regardless of its contractual label) will be deemed to be unenforceable by the courts. This article examines the contractual relief of liquidated damages and explores the circumstances where a court might be prepared to deem a clause as an unenforceable penalty.

The need for protection against delay

Delays on a technology project are not an unfamiliar occurrence. In fact, delays to agreed contractual milestones are a potential hallmark of large-scale technology, IT and outsourcing projects. In order to protect their legitimate interests, suppliers and customers often build into project documentation several mechanisms that will be triggered in the case of delay, namely:

• delay relief notices to be served by the supplier where it requests to be excused from liability for any non-culpable delay;
• provisions relating to force majeure and material adverse change – (see article on Force Majeure and Frustration); and
• in some cases, termination rights in the case of critical delays to the project – (see article on Termination).

Additionally, parties may agree that liquidated damages shall be payable by one or more of the main contracting parties or sub-contractors where there are significant delays to agreed commitments on a project.

The unprecedented disruption to the technology sector caused by COVID-19, for example due to labour shortages or difficulties with the supply of materials, has brought into sharper focus the need for project parties to rely upon liquidated damages provisions in the case of delay.

What are liquidated damages?

Liquidated damages are damages which are agreed during the formation of a contract to compensate an innocent party following a defaulting party’s breach of contract. They are often included in supply contracts to compensate a customer for a supplier's late delivery or technical performance shortfalls. Delay liquidated damages are usually expressed as a specified rate per day which represents the estimated extra costs incurred and losses suffered for each day of delay.

From a customer perspective, liquidated damages can be advantageous for several reasons. By comparison with a claim for general damages for a breach of contract, liquidated damages have the benefit of not being subject to the rules on mitigation and remoteness. Further, they avoid the complexity of assessing and evidencing actual loss where delay occurs. Consequently, should the relevant term (for example, a contractual milestone for delivery) be breached, a non-defaulting party simply has to prove that the defaulting party breached the relevant term (rather like a debt claim). The innocent party does not need to prove that the breach resulted in a loss. In fact, the liquidated sum will be recoverable regardless of whether or not a loss is actually suffered.

Liquidated damages can also prove advantageous to suppliers. In a project where liquidated damages provide an exhaustive remedy for delays, the contractor will know, from the outset of the project, exactly how much it will have to pay if it cannot complete the works by the customer's deadline. This will aid planning cash flows throughout the life-cycle of a project.

What is a penalty clause?

Whether a liquidated damages provision amounts to an unenforceable penalty is a question of construction. This will turn on the specific circumstances of the case.

The starting point is that courts will seek generally to uphold the principle that parties are free to contact on the terms that they choose. Therefore, the courts are often reluctant to disrupt the parties' bargain by holding that a clause negotiated between them is a penalty.¹

However, where a purported liquidated damages clause is drafted so as to penalise a party for a breach and, in effect, to discourage a party from deliberately breaching its obligations, a court may deem this to be an unenforceable penalty clause.

This principle was established over 100 years ago in the Dunlop case² where Lord Dunedin explained that “the essence of liquidated damages is a genuine covenanted pre-estimate of damage … it will be held to be a penalty if the sum stipulated for it is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.”

Until 2015, this was understood to be the legal test for the rule on penalties.

The modern law on penalties

The law on penalties, first set by Dunlop, was reformulated by the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi and Parking Eye Ltd v Beavis [2015] UKSC 67. Lord Neuberger and Lord Sumption held that:

“The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss ... The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. […] 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.”³

While the Supreme Court refused to abolish the penalty rule altogether, Lord Neuberger and Lord Sumption were clear to limit its application. Accordingly, even if a liquidated damages clause does not represent a genuine pre-estimate of loss, it does not necessarily follow that the clause would be deemed to be a penalty.

The reformulated rule against penalties is therefore whether the remedy prescribed by the clause is out of all proportion to the legitimate interests of the innocent party.

This reformulation is likely to make it easier for customers to negotiate enforceable liquidated delay payments for late delivery of works.

What factors do the courts consider when assessing the enforceability of a liquidated damages clause?

Following Cavendish Square Holding, subsequent case law suggests that the ambit of the law on penalties is narrow, as it interferes with the key principle of freedom of contract.⁴ Further, this would create an undue level of uncertainty in parties' commercial agreements.

The narrow ambit of the law was demonstrated recently where it was held that “the modern trend is for the courts to be reluctant, as regards commercial parties, to strike down a payment as a penalty”.⁵

In determining the enforceability of a liquidated damages clause, a court would likely take the following into account:

• the circumstances of the contract as a whole viewed at the time the relevant term was agreed (i.e. not at the time the breach occurs);
• the precise wording of the clause and the objective intention of the parties behind the provision. Use of terms such as “penalty” and “liquidated damages” will be taken on face value but will not be regarded by a court as conclusive;
• any difference between the level of liquidated damages stipulated in the contract and the level of damages which have been suffered by the non-defaulting party;
• notwithstanding this, even if the liquidated damages clause does not constitute a genuine pre-estimate of loss, it does not follow that this will automatically be a penalty. The defaulting party, to evidence a penalty, must demonstrate “an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach.”⁶ A mere discrepancy is likely to be insufficient – to illustrate this, the Court of Appeal held that “a contractual provision does not become a penalty simply because the clause in question results in overpayment in particular circumstances. The parties are allowed a generous margin.”⁷;
• the relative bargaining power of the contracting parties (the honesty or motive of the parties is irrelevant in determining the enforceability of the clause). This arose in Cavendish Square Holding, where the Supreme Court acknowledged that “in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach”; and
• whether the parties had legal representation.

Top tips for drafting liquidated damages provisions

Liquidated damages provisions for delay provide a degree of certainty for both suppliers and customers on an IT or technology project, although careful drafting is critical. It is important to keep the following “top tips” in mind:

1. best practice is to sit down and calculate your probable losses as a result of delays to certain contractual milestones;
2. this loss calculation should be shared with the other side as part of the negotiation process ( or at the very least retained as evidence should a dispute arise) . Notes should be made of any discussions on this. They could prove crucial in demonstrating to the court that the amount does not represent a penalty;
3. consider including a provision that provides for some level of liquidated damages to both contracting parties. This may be viewed more favourably by the court than a provision designed to protect only one of the contracting parties;
4. consider building into the contract the reason for the inclusion of the liquidated damages clauses and why it is set at a particular level. Failing this, it is important to keep a written note of all negotiations as such notes will be admissible as evidence in a dispute over the clause; and
5. consider an express acknowledgment by the parties that the clause is not a penalty; is enforceable and reasonable, and is ultimately included to protect the legitimate interests of the party concerned.

To conclude – whilst liquidated damages are included in IT contracts to add certainty when there is delay and/or a dispute – the reality is they can be fraught with uncertainty and ironically lead to a dispute particularly when “cash is king” during the ongoing COVID-19 crisis.

Please contact the DLA Piper Tech Disputes Team for further advice.

¹ Hong Kong Ltd v. Attorney General of Hong Kong (1993) 61 BLR 41
² Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Company Limited [1915] AC 79
³ Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67
⁴ CFL Finance Ltd v Bass [2019] EWHC 1839 (Ch)
⁵ ICICI Bank UK Plc v Assam Oil Co Ltd [2019] EWHC 750 (Comm)
⁶ Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67
⁷ Murray v Leisureplay plc [2005] IRLR 946