The Legitimate Interest Test (UK) on the Enforceability of Liquidated Damages Clauses and its Implications for Indian Law

Commercial contracts stipulate liquidated damages1 as a standard remedy for breach. The liquidated damages clause comes in a variety of forms, like provisions for payment or forfeiture of stipulated sums, formulae for determination, directions for compulsory transfer of property.2 Lawyers design these clauses to meet contract-specific requirements. Determination of damages falls within the natural domain of judicial assessment, being a matter to be tried and decided based on the evidence adduced. In this light, permitting the contracting parties to agree upon the damages in the contract implies an inroad into the judicial function. Common law jurisdictions, therefore, treat liquidated damages as a justiciable issue and the freedom of contract is far from absolute.

 

In common law jurisdictions, such as the United Kingdom, Australia, New Zealand, Singapore, courts have been exercising substantive judicial review over these clauses, with a view to ensure that the award of damages is restricted to fair compensation for losses suffered. Commonwealth nations, like India and Malaysia, which have codified contract law, have statutory provisions that achieve the same effect.3 Civil law jurisdictions, such as France, Italy and Germany, despite their avowedly limited review of liquidated damages provisions4, empower courts to grant a reduced amount towards damages if the liquidated damages clause stipulate a sum found to be manifestly excessive.5

 

In 2015, the United Kingdom Supreme Court (“UKSC”) broke new ground in Cavendish Square Holding BV v. Makdessi6 (“cavendish”). The vintage position on liquidated damages, based on its contradistinction with penalties, was crystallised by the Lord Dunedin of the House of Lords in Dunlop7 in 1915. The UKSC in Cavendish6 found the Dunlop7 tests to be inadequate to deal with liquidated damages clauses in modern commercial contracts. The Court found that the Dunlop7 tests were meant for assessing ordinary damages, and could no longer be considered apposite to deal with liquidated damages clauses of a more complex variety found in contemporary contracts. For the modern contracts, the UKSC devised a novel test viz. a provision for liquidated damages deserves to be enforced provided that the detriment imposed is not out of all proportion to the legitimate commercial interests the aggrieved party has in the enforcement of the primary obligations under the contract.8

 

This revolutionary test has been applied in subsequent decisions in the United Kingdom. Moreover, common law jurisdictions, like Australia, New Zealand, Singapore and Malaysia, have applied the Cavendish6 formulation in a variety of fact-situations. A wealth of judicial and academic discussion on the subject has, thus, been generated over the last five years across the world. However, superior courts in India have not had an occasion to effectively deliberate upon the new test yet.9 This essay seeks to appreciate the contours of the “legitimate interest” test developed in the United Kingdom, study its application through various rulings handed down by courts globally, and explores the possibility of the assimilation of the “legitimate interest” test in Indian law and the common law jurisdictions in general.

 

THE “LEGITIMATE INTEREST” TEST AND ITS APPLICATION IN THE UNITED KINGDOM

  1. The Dunlop10 Tests (1915)

In Dunlop10, the House of Lords crystallised the legal position on liquidated damages in the form of four tests11 designed to distinguish valid liquidated damages provision from one attracting the vice of being in the nature of penalty and hence unenforceable:

(a) If the sum stipulated is extravagant and unconscionable in comparison with the greatest loss arising from the breach that could conceivably be proved, then the clause is in the nature of a penalty.

(b) If the breach complained of is non-payment of an amount and the clause in question stipulates payment of a greater amount as a remedy, then the clause will be treated as penalty.

(c) There is a presumption that the clause amounts to a penalty, when a single lumpsum amount is directed to be paid by way of remedy for the breaches which consist of one or more or all of several events, some of which may occasion serious and others trifling damage.

(d) If it is impossible to pre-estimate the quantum of damages, then it is probable that the amount named in the clause is a genuine pre-estimate of damages and, hence, a valid liquidated damages clause.

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*The article has been published with kind permission of Eastern Book Company. Cite as (2021) 2 SCC J-37

BA, LLB (Hons.), NLSIU, Bangalore and Advocate, Bombay High Court. The author thanks Mr Arvind P. Datar, Senior Advocate, for his guidance and comments on a previous draft of this piece.

1 “Liquidated damages” refers to the stipulated and agreed damages provided for in a contract as and by way of compensation for the breach of a significant or material nature.

2Ewan McKendrick (Ed.), Goode on Commercial Law (5th Edn.) 134-5 (London, UK: Penguin, 2016). Usually, the transfer of shares, debentures, etc. is specified as compensation by way of liquidated damages.

3 The Indian Contracts Act, 1872 (Section 74) and the Malaysian Contracts Act, 1950 (Section 75).

4 M. Berger, “Damages and International Contract Law”, 4 IBLJ 427-443 (2004).

5 M. Armandola, “Liquidated Damages in International Arbitration”, 2 IBLJ 2013 99-107; Ugo Draetta et al, “Liquidated Damages and Penalty Clauses in International Trade Practice”, 3 IBLJ 1993 261-272; M. Pargendler, “The Role of the State in Contract Law”, 43 Yale J Int’l Law 143 (2018); L, Miller, “Penalty Clauses in England and France”, ICLQ 2004, 53(1), 79-106; P. Rosher, “Delay analysis in international construction projects: a comparative study in English and French law”, 6 IBLJ 427-443 (2014).

6[2016] A.C. 1172 : 2015 UKSC 67 (“Cavendish”) (Seven-Judge Bench). The UKSC was deciding two distinct appeals in this case:

(i) Cavendish Square Holding BV v. Makdessi and

(ii) ParkingEye v. Beavis. They are collectively referred to in this Article as “Cavendish”.

7Dunlop Pneumatic Tyre Co. Ltd. v. New Garage & Motor Co. Ltd., [1915] A.C. 79 (HL) (Four-Judge Bench) (“Dunlop”).

8Cavendish Square Holding BV v. Makdessi, [2016] A.C. 1172 : 2015 UKSC 67 (“Cavendish”) (Seven-Judge Bench), per Lord Neuberger of Abbotsbury and Lord Sumption. This test is referred to hereinafter variously as “the Cavendish test/formulation” and “the legitimate interest test”.

9 The only Indian ruling referring to Cavendish, [2016] A.C. 1172 : 2015 UKSC 67 is the Madras High Court judgment in Electronics Corpn. of T.N. Ltd. v. ICMC Corpn. Ltd., 2020 SCC OnLine Mad 244 (para 19), wherein the Court merely cited certain stray sentences from the Cavendish, [2016] A.C. 1172 : 2015 UKSC 67 ruling and did not elaborate on either the judgment or its effect on the Indian law on the subject.

10Dunlop Pneumatic Tyre Co. Ltd. v. New Garage & Motor Co. Ltd., [1915] A.C. 79 (HL) (Four-Judge Bench) (“Dunlop”), at pp. 87-88.

11 These four tests were founded on previous rulings viz. Kemble v. Farren, (1829) 6 Bing 141 : 130 ER 1234; Commr. of Public Works v. Hills, [1906] A.C. 368 (PC); Webster v. Bosanquet, [1912] A.C. 394 (PC); Clydebank Engg. & Shipbuilding Co. Ltd. v. Don Jose Ramos Yzquierdo Y. Castaneda, [1905] A.C. 6 (HL), inter alia.

12 The more important ones amongst these are: Bridge v. Campbell Discount Co. Ltd., [1962] A.C. 600 : [1962] 2 WLR 439 (HL), Ariston SRL v. Charly Records, 1990 WL 753432 (CA); Murray v. Leisureplay, 2005 EWCA Civ 963 (CA); CMC Group Plc. v. Zhang, 2006 EWCA Civ 408 (CA); Lansat Shipping Co. Ltd. v. Glencore Grain BV, 2009 EWCA Civ 855 (CA).

13 The Cavendish, [2016] A.C. 1172 : 2015 UKSC 67 ruling is also debated for its inroads into the “rule against penalties” in the United Kingdom. However, this aspect of the decision is not relevant for our purposes and hence, has not been elaborated here. Section 74 of the Contract Act, 1872 which deals with liquidated damages in India has done away with the distinction between damages and penalty. See: Fateh Chand v. Balkishan Dass, AIR 1963 SC 1405 (Five-Judge Bench).

14 Id, 1247, para 152.

15Cavendish Square Holding BV v. Makdessi, [2016] A.C. 1172 at pp. 1247-48: 2015 UKSC 67.

16 Robert Elliot, “Penalties: A Brief Guide to Three Revolutions”, 32(6) Construction Law Journal 644-658 (2016).

17 Lorna Richardson, “Commercial justification for penalty clauses: the death of the old dichotomy?”, 19(1) Edinburgh L Rev 119-124 (2015); William Day, “A Pyrrhic Victory For the Doctrine Against Penalties”, 2 Journal of Business Law 115-127 (2016); Bobby Lindsay, “Penalty Clauses in the Supreme Court: a Legitimately Interesting Decision?”, 20(2) Edinburgh L Rev 204-210 (2016); Mark Stamp, “The Penalty Rule in Corporate Contracts – Is it Offside?”, 37(7) Company Lawyer 219-222 (2016).

18 Solene Rowan, “The Legitimate Interest in Performance in the Law on Penalties”, 78(1) Cambridge Law Journal 148-174 (2019); Mathias Cheung, “Shylock’s Construction Law: The Brave New Life of Liquidated Damages?”, 33(3) Construction Law Journal 173-187 (2017); Prof. Larry DiMatteo, “An Examination of Judicial Reasoning – When A Penalty Is Not A Penalty”, 85 Geo Wash L Rev 1846 (2017); Jonathan Morgan, “The Penalty Clause Doctrine: Unlovable But Untouchable”, 75 Cambridge Law Journal 11 (2016).

19 Solene Rowan, “The Legitimate Interest in Performance in the Law on Penalties”, 78(1) Cambridge Law Journal 148-174 (2019). A similar view is expressed in Sam Cathro et al, “New Variations on the Rule Against Penalties: Options for New Zealand”, 27 NZULR 1087 (2017).

20Ewan McKendrick (Ed.), Goode on Commercial Law (5th Edn.) 134-5 (London, UK: Penguin, 2016).

21 Solene Rowan, “The Legitimate Interest in Performance in the Law on Penalties”, 78(1) Cambridge Law Journal 148-174 (2019).

22(2016) 8 WLUK 293 (Court of Session – Inner House, Scotland) (Three-Judge Bench).

232017 EWHC 350 (Ch) (High Court of Justice – Chancery Division).

242017 EWHC 3288 (Comm) (High Court of Justice – QBD: Commercial Court).

252017 EWHC 3397 (Ch) (High Court of Justice – Chancery Division).

26 The increased rate applicable in case of default in this case was LIBOR + 10 %.

272018 EWHC 2866 (Comm) (High Court of Justice – QBD: Commercial Court).

282018 EWHC 402 (Ch) (High Court of Justice – Chancery Division).

29 Since what was levied under the clause was the normal market rate, there was no question of it being exorbitant or unconscionable.

302018 WL 02107059 (High Court of Justice – Chancery Division).

312019 EWHC 476 (Comm) (High Court of Justice – Queen’s Bench Division).

32 The increased rate applicable in case of default in this case was LIBOR + 12 %.

33 Michael Furmston, “Recent Developments about Penalties”, 28 (1) NLSI Rev 18 (2016).

342016 HCA 28 (Five-Judge Bench).

35 Bruno Zeller, “Penalty Clauses – What Has Changed?”, 30 Pace Int’l L Rev 147 (2017).

362017 WL 2730505 (Three-Judge Bench).

372016 NSWCA 328 (Three-Judge Bench).

382017 NZCA 152 (Three-Judge Bench).

392019 NZCA 122 (Three-Judge Bench).

402016 SGHC 77.

41Cavendish Square Holding BV v. Makdessi, [2016] A.C. 1172, at p. 1216: 2015 UKSC 67.

422016 SGHC 144.

43 GOH Yihan and Yip Man, “English Reformulation of the Penalty Rule: Relevance in Singapore”, 29 Singapore Academy of Law Journal 257 (2017).

44(2019) 2 CLJ 723 (Malaysia) (Five-Judge Bench).

452019 SCC OnLine MYCA 58 (Three-Judge Bench).

46 Larissa Welmans et al, “The ‘Interest’ Based Penalty Tests in Paciocco and Cavendish/Parkingeye and the Law of Penalties and Damages in Australia and the United Kingdom”, 43(2) University of Western Australia Law Review 174 (2018).

47 Jessica Palmer, “Implications of the New Rule against Penalties”, 47 Vict. U. Wellington L Rev 305 (2016).

48 The Supreme Court of India is the highest Court in the country, charged with the constitutional mandate to lay down the law, under Article 141 of the Constitution of India.

49(2015) 4 SCC 136 (Two-Judge Bench).

50 The Court relied on a host of precedents, prominent among them being (a) Fateh Chand v. Balkishan Dass, AIR 1963 SC 1405 (Five-Judge Bench), (b) Maula Bux v. Union of India, (1969) 2 SCC 554 (Three-Judge Bench), and (c) ONGC Ltd. v. Saw Pipes, (2003) 5 SCC 705 (Two-Judge Bench).

51 This view is consistent with the Privy Council’s ruling in Bhai Panna Singh v. Bhai Arjun Singh, 1929 SCC OnLine PC 43 : AIR 1929 PC 179 (Three-Judge Bench) (per Lord Atkin), which construed Section 74 to require proof of damages suffered.

52Kailash Nath Associates v. DDA, (2015) 4 SCC 136 (Two-Judge Bench), paras 43 to 43.7, at pp. 162-3.

53 The provision on liquidated damages viz. Section 75 of the Malaysian statute, is identical to the corresponding provision in Indian law, section 74 of the Contract Act, 1872.

54Kailash Nath Associates v. DDA, (2015) 4 SCC 136 (Two-Judge Bench) paras 43 to 43.7.

55 An illustrative list of such judgments includes:

(i) Satya Jain v. Anis Ahmed Rushdie, (2013) 8 SCC 131 and

(ii) Transmission Corpn. of Andhra Pradesh Ltd. v. GMR Vemagiri Power Generation Ltd., (2018) 3 SCC 716 [on the application of the “business efficacy” test];

(iii) BALCO v. Kaiser Aluminium Technical Services Inc., (2012) 9 SCC 552 (Five-Judge Bench) [on the interpretation of provisions in the Arbitration and Conciliation Act, 1996];

(iv) Dyna Technologies (P) Ltd. v. Crompton Greaves Ltd., (2019) 20 SCC 1 (Three-Judge Bench) [on the permissibility of unreasoned arbitral awards];

(v) Markfed Vanaspati & Allied Industries v. Union of India, (2007) 7 SCC 679 [on the duties of arbitrators];

(vi) Mary v. State of Kerala, (2014) 14 SCC 272 [generally on the construction of commercial contracts].

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