Guarantees and Indemnities and whether liquidated damages clauses amount to unenforceable penalties?

Do liquidated damages clauses amount to unenforceable penalties? What is the difference between a guarantee and indemnity?

The background

GPP entered into five substantially similar contracts with Prosolia for the construction of solar power generation plants across the UK.  Solar is Prosolia’s parent company, who had guaranteed Prosolia’s obligations in four of the five contracts (the Contracts). 

Prosolia became insolvent.  The Contracts contained liquidated damages clauses (the LD Clauses) covering delays in commissioning.  GPP claimed liquidated damages for Prosolia’s failure to commission each plant by the date specified in the relevant contract, against Solar as Prosolia’s guarantor. 

The main issues for the Court to decide were: (i) did the LD Clauses in the Contracts amount to unenforceable penalties; and (ii) was Solar liable for GPP’s losses under the Contracts pursuant to a guarantee or an indemnity?

The decision

Liquidated damages or penalties?

Solar argued the LD Clauses should be construed as unenforceable penalties, because the daily rate of liquidated damages accruing under each of the Contracts was the same, despite applying to different plants with differing energy outputs.  Further, the LD Clauses had not been subject to detailed negotiation between the parties, and were each referred to as a “penalty”.

The Court rejected Solar’s arguments, and found the LD Clauses to be neither penalties, nor unenforceable.  The Court applied the Supreme Court decision in Cavendish Square Holdings BV v Makdessi and ParkingEye Ltd v Beavis [2015] (Makdessi).  Under Makdessi, the Court needed to decide if the LD Clauses were “out of all proportion to any legitimate interest of innocent party in the enforcement of the primary obligations” and/or whether the sums stated were “extravagant, exorbitant or unconscionable”.

The Court decided that, while the sums agreed under the LD Clauses were not a precise calculation of the financial losses conceivable, they did not exceed a genuine attempt to estimate in advance the loss GPP might suffer. 

The Court also dismissed the argument that the LD Clauses had not been the subject of detailed negotiation; the parties were sophisticated and experienced commercial entities, with equal bargaining power.  Further, use of the word ‘penalty’ in the wording of the LD Clauses was immaterial; the substance of the LD Clauses was clear. 

Indemnity or guarantee

Solar also argued that its obligations under the Contracts applied to it as a guarantor, not as an indemnifier.  Solar argued that Prosolia had: (i) failed to disclose “unusual features” regarding the project before Solar had entered into the guarantee; and (ii) failed to consult Solar on a significant change to the logistics of the project, which varied Solar’s contractual obligations under the Contracts.  Accordingly, Solar, as guarantor, could be discharged from any liability under the doctrine of guarantee law. 

The Court dismissed this argument, concluding that the guarantee clause included a ‘separate and independent obligation and liability’ as an indemnity.  This guarantee was expressed as a promise to indemnify, and was ‘written in language characteristic of indemnities’.  Solar was therefore liable for GPP’s losses pursuant to an indemnity. 

Why is this important?

This case is a good example of the modern approach to liquidated damages/penalties – it is no longer merely a question of whether it is a genuine pre-estimate of losses.

This case also confirms that, in the case of a negotiated contract between equal and sophisticated commercial parties, the Court will consider the parties themselves to be the best judges as to appropriate level of liquidated damages.

The decision is also a useful reminder of the advantages of an indemnity (a primary obligation) over a guarantee (a secondary obligation).

Any practical tips?

Parties should be careful to ensure liquidated damages clauses are proportionate to the likely losses, and not extravagant or unconceivable.  Expressing payments as primary obligations as opposed to damages can also assist recovery.

Parties seeking to have the benefit of a third party guarantee should ensure all of the usual guarantee protections are in place (eg no release by reason of variation, delay, forbearance, etc) and ideally have a supporting indemnity (as a primary rather than a secondary, obligation).