The rule on penalties in Makdessi applied to EPC contracts

The decision in (1) GPP Big Field LLP and (2) GPP Langstone LLP v Solar EPC Solutions SL (formerly known as Prosolia Siglio XXI) [2018] EWHC 2866 (Comm) has applied the Supreme Court's recast penalties test from Makdessi¹. The decision is one of the few construction cases that have applied Makdessi in determining whether liquidated damages for delay are unenforceable as a penalty. The court also considered the validity of a force majeure notice and liability of a parent company under an indemnity/guarantee.

Recap of Makdessi and how it applies to construction contracts

In Makdessi, the Supreme Court reformulated the rule on penalties under English law from the longstanding "genuine pre-estimate of loss" test established in Dunlop² into the "legitimate interest" test. The focus of the prevailing test following Makdessi is now whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when viewed in the context of the innocent party's legitimate interest in the performance of the contract.

In relation to construction contracts, the penalties doctrine finds most frequent application when raised to defeat a claim for liquidated damages for delay, which is a regime common to most construction contracts. This case helps to explain how the courts will apply the reformulated test in Makdessi in the context of a construction dispute.

Facts

GPP (Employer) engaged Prosolia UK Ltd (Contractor) under separate EPC contracts to construct five solar plants throughout the United Kingdom. The contracts proved unprofitable for the Contractor, leading to the Contractor's insolvency. The Employer brought a claim against Solar, the Contractor's parent company (Parent Company) for liquidated damages for delay arising as a consequence of the Contractor's late and/or non-completion of the works under four of the EPC contracts. The Parent Company defended the liquidated damages claims on several grounds, including:

1. that the delay liquidated damages clauses were unenforceable as penalties;
2. that the Contractor was relieved of its obligation to achieve "commissioning" by the contractual date because a substantial part of any relevant delay was caused by force majeure;

that based upon equitable doctrines applying to guarantees, the Parent Company was discharged from liability as guarantor.

Delay liquidated damages as a penalty

Each of the EPC contracts provided for the same delay damages rate of £500 per day per MWp, even though each of the plants had a different output with varying expected electricity prices, and the extent of loss likely to be suffered was dependent on the output of the plant and prevailing electricity price. The Employer claimed liquidated damages for delay under four of the EPC contracts. The Parent Company argued that the delay damages provisions were unenforceable as penalties.

The judge found that the delay liquidated damages provisions did not exceed a genuine pre-estimate of loss, and that the sums were not in any way extravagant or unconscionable in comparison with the legitimate interest of the Employer in ensuring timely performance of the contracts.

The court's decision to uphold the liquidated damages provisions was based on the following reasons:

• Liquidated damages provisions of the kind found in the EPC contracts were common in construction contracts.
• The parties were experienced and sophisticated commercial parties of equal bargaining power, who were capable of assessing the commercial implications of the liquidated damages provisions.
• The sum of liquidated damages under each contract was stated to be a round sum paid irrespective of the effect of the delay in question; but it was in the nature of liquidated damages clauses that they are often used in cases where precise prediction of the likely loss is difficult, and are therefore often expressed in round figures.
• The sum provided for in each liquidated damages clause was payable only on a single type of breach; and the fact that the loss resulting from that breach may vary in amount depending on the actual circumstances at the time does not of itself give rise to any inference that the sum agreed to be paid is a penalty, provided that it is not extravagant and unconscionable in amount in comparison with the greatest loss that might have been expected when the contract was made to be likely to flow from the breach.

One of the arguments raised by the Parent Company was that the inclusion of the word "penalty" in the delay liquidated damages clause was a "powerful indicator" that the clause was intended to punish the Contractor, rather than compensate the Employer for the Contractor's breach. The relevant clause provided:

"In the event of the delay of more than fifteen (15) calendar days for the date of commissioning, the Contractor shall pay to the [Employer] a penalty…The maximum of the penalty for delays of the Works shall be two hundred and fifty thousand pounds sterling per MWp (£250,000/MWp)." (Emphasis added.)

However, the court rejected this argument, finding that the reference to the sum as a "penalty" was nothing more than an equivocal indication, requiring an enquiry into the substance of the matter.

Further, in arriving at its decision, the court had regard to the "genuine pre-estimate of loss" test from Dunlop, demonstrating that whether liquidated damages are a genuine pre-estimate of loss remains a relevant consideration. This decision also lends support to the proposition that, under the Makdessi test, delay liquidated damages that ensure timely performance of a contract will typically be construed by the courts as serving and protecting a "legitimate interest" of an employer in the context of a construction contract.

Force Majeure

Another defence raised by the Parent Company to the Employer's claim for delay liquidated damages under one of the EPC contracts was that the Contractor had been relieved of its obligation to achieve "commissioning" by the contractual date due to force majeure.

As part of the works, the Contractor was required to lay 5km of cabling in underground trenches from one of the solar plants to a substation. After some of the cabling had been laid, the Contractor claimed that local residents objected to the cabling being laid, which, in turn, culminated in protests. The "Villagers' Revolt" (as it was described by the Parent Company) allegedly prevented the continuation of the cabling works as villagers had created human barriers and were physically jumping into and occupying the trenches. According to the Parent Company, the Contractor was therefore compelled to abandon the partially constructed cabling, and was required to re-lay the cabling over a longer, and less proximate, route.

The Contractor argued that the "Villagers' Revolt" amounted to a "disturbance, commotion or civil disorder" or "acts of... sabotage" within the meaning of force majeure under the relevant contract. However, based on the Contractor's evidence, the court was not persuaded that there had, in fact, been any physical obstruction to the works caused by local residents, which amounted to force majeure. Rather, the court found that the delay was caused by the Contractor's assessment that it was unlikely to gain the necessary planning permissions and other consents for its originally intended cable route (which was the Contractor's risk).

A further issue that arose was whether an informal notice complied with the notification requirements under the force majeure provisions, which made it a condition precedent that the party claiming relief must notify the other party of the event without unjustified delay. The contract also required that all notices and communications between the parties were either in writing or were confirmed in writing within the following five calendar days.

Although the Parent Company produced evidence that the Employer had received notice through informal phone calls and emails from time to time (albeit sporadically), the court was again not persuaded that sufficient notice had been given to allow the Contractor to rely on the force majeure provisions. In this regard, the court highlighted that the invocation of force majeure is a formal step, and it makes perfect commercial sense for the parties to require that formal step to be taken by formal written notification.

The court's decision reinforces the importance of complying with notification requirements under a construction contract generally, but especially where non-compliance gives rise to material financial consequences. Further, as the court noted, formal notification of force majeure events is mandatory to enable an Employer to monitor the situation and, where possible, to take action with the Contractor to bring an end to the period of delay.

The Parent Company guarantee/indemnity

Under one of the EPC contracts, the Parent Company had agreed to:

• "guarantee[s] the due and punctual performance by the Contractor of the Contractor's duties and obligations"; and
• "indemnify [the Employer] against all loss, debt, damage, interest, cost and expense incurred" by the Employer.

An issue arose as to whether the second clause operated as a guarantee or as an indemnity; and, relatedly, whether the Parent Company's obligation as guarantor/indemnifier was discharged by virtue of the equitable doctrines protecting guarantors on the basis that: (i) the Employer had failed to disclose a number of "unusual features" before the Parent Company entered into the guarantee; and (ii) the relevant contract had been varied without its consent (when the Employer and Contractor agreed to change the cabling route).

Having considered the language of both clauses, the court decided that, on balance, the second clause should be characterised as an indemnity rather than a guarantee. Among other things, the court noted that the promise given in the contract was described as “a separate and independent obligation and liability”. It was expressed as a promise to “indemnify”; and written in the language characteristic of indemnities, focusing on the “loss, debt, damage, interest, cost and expense incurred” by the Employer. The court further found that the equitable protections relied on by the Parent Company applied only to contracts that are properly characterised as contracts of guarantee, and do not apply to contracts of indemnity, any more than they apply to on-demand bonds or to standby letters of credit.

In approaching this issue, the court provided a useful summary of the legal distinction between a guarantee and indemnity: under a guarantee, there will always be a principal debtor and a secondary debtor. By contrast, an indemnity is a form of independent and primary obligation and so is not secondary to, nor dependent upon, the liability of any other obligor.

The decision is also a reminder that the courts will primarily examine the words used to express a promise in the contract to determine whether the nature of the obligation created is that of an indemnity or guarantee. It therefore remains important that clear and consistent drafting is used when the parties intend for a parent company guarantee to operate as an indemnity (or guarantee).

^{1. Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67}

^{2. Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79}