The enforceability of liquidated damages clauses and minimum purchase commitments
STERIA v SIGMA, ASSOCIATED BRITISH PORTS v FERRYWAYS and M&J POLYMERS v IMERYS MINERALS [2008]
It is now quite well established that the Courts are very reluctant to intervene to strike down provisions agreed between commercial organisations under which pre-agreed financial compensation is payable in the event of specified breaches. Such liquidated damages provisions are often payable in the event of delays or, where performance is being measured against agreed service levels, for failures of the service provider to meet the service level obligations. These are typically called service credits.
Liquidated damages provisions are not enforceable if they amount to a penalty but the circumstances in which a provision will be regarded as a penalty are increasingly rare and in some cases of minimum purchase commitments the rules against penalties may not be applicable at all.
Steria v Sigma
Steria sought to argue that liquidated damages for delay at various stages of a project under a sub-contract amounted to a penalty because equivalent provisions were not contained in the prime contract. The fact that the sub-contract under which Steria were working contained liquidated damages provisions for interim phases which provisions were absent from the prime contract did not automatically lead to the conclusion that the provisions of the sub-contract were a penalty.
Associated British Ports v Ferryways
- The parties entered into an agreement for handling cargo containers at a port. The agreement contained a ‘minimum throughput’ obligation which provided that, if the number of units (as defined) fell below a certain number in each year, the customer would nevertheless be obliged to pay a fee equivalent to the shortfall. The customer subsequently argued that this was a penalty.
- The Judge, however, noted that, on the correct construction, the aim of the clause was to provide the supplier with a certain annual revenue stream and not to threaten the customer into performing. The obligation was not a secondary one, triggered by a breach, but was instead a primary obligation given in exchange for a promise by the supplier "… and as such could not be a penalty". Importantly, the sum payable in respect of any shortfall whilst the agreement was ongoing was to be regarded as a debt claim rather than a claim for damages and would therefore not be subject to mitigation in terms of costs saved and alternative sources of business. Sums claimed in respect of the period post termination were general damages and were subject to the duty to mitigate.
M&J Polymers Limited v Imerys Minerals
A similar issue was raised in this case which involved a "take or pay" clause in an agreement for the supply of dispersants.
- The buyer was obliged to pay for minimum quantities of materials even if it had not ordered them. One of several points which the Court had to decide was whether this clause constituted a penalty.
- The Judge commented that the clause was "not the ordinary candidate for such rule", but the law on penalties could potentially apply, simply because the obligation to pay arose (in this context) following a breach of the obligation to order. Counsel for the buyers raised the point that, in such cases, the obligation to pay the price might result in payment of a sum in excess of the supplier's loss.
- The Court was not convinced by this. It said it was perfectly conceivable that storage costs, or the possibility that the goods had become unsaleable, could mean that the supplier's losses would easily exceed the price.
- The Court stated that a clause such as this could survive the penalty rule if that sum payable was commercially justifiable, provided the clause's primary purpose was not to deter a breach. In fact, the commercial justification test proved decisive here. At the time the parties negotiated the contract, raw materials were in extremely short supply. Although the supplier was willing to commit supply to the customer, in return it expected a commitment to take a minimum quantity. Negotiations had taken place involving a lot of give and take to agree a minimum term acceptable to both and to agree exactly how the take or pay clause would operate. The Court was therefore "entirely satisfied" that the clause did not offend the penalty rule.
points to note:
- The result of these cases is clearly that the rule against penalties is becoming something which can be relied upon only in very extreme cases. They illustrated that if amounts are payable under a contract as a primary obligation they are unlikely to constitute a penalty.
- Caution should therefore be exercised before a supplier or service provider places undue reliance upon the Courts striking down agreed liquidated damages provisions as a penalty.