Liquidated damages – a penalty or not?
AZIMUT-BENETTI v HEALEY [2010]
The test for determining when a liquidated damages provision constitutes a ‘penalty’ and hence when it is unenforceable was considered in this case. The Court adopted a ‘commercial justification test’ and viewed the clause in question as seeking to strike a balance between the commercial interests of the parties.
Facts:
- A was a yacht builder which agreed to construct and sell a yacht to a company, S. H owned S and gave a guarantee in relation to S’s liabilities.
- Under the termination clause in the contract it was agreed that if S failed to pay and A terminated as a result, A could retain 20% of the contract price as liquidated damages and, subject to that retention, would then promptly return the balance of any sums previously paid by S.
- The price for the yacht was €38m and, following S’s default, A claimed liquidated damages of about €7m from H under the guarantee. H resisted this claim on the basis that the liquidated damages provision amounted to a penalty clause which would therefore be unenforceable.
- A denied this but also raised another argument that even if the liquidated damages did amount to an unenforceable penalty, H was nonetheless liable under the guarantee on the basis of a provision stating that the guarantee would not be rendered unenforceable by reason of any “irregularity, illegality, unenforceability or invalidity” in the underlying construction contract.
- H argued in return that as the liquidated damages provision was a penalty clause and could not be enforced, there was no liability to which the guarantee could fasten.
Decision:
- Liquidated damages (sometimes called ‘service credits’ in services contracts) are a way of limiting liability whilst at the same time providing the innocent party with a pre-defined remedy. Such clauses operate by way of a pre-agreed obligation to make certain payments which are triggered by a particular, identified breach of contract and have to be a genuine pre-estimate of loss in order to be enforceable. Interestingly in this case, the Court did not think it was necessary to give an opinion as to whether the liquidated damages clause was a genuine pre-estimate of loss. It did not assess the maximum possible loss that the parties could have expected to flow from any termination of the contract and the extent to which the liquidated damages figure exceeded that maximum possible loss.
- Instead it adopted the ‘commercial justification test’ in that “a clause may be commercially justifiable provided that its dominant purpose is not to deter the other party from breach”. The Judge viewed the clause in question as seeking to strike a balance between the commercial interests of the parties if A lawfully terminated the contract due to S’s breach. He concluded that this commercial rationale for the liquidated damages provision was evidenced by the parties’ pre-contractual negotiations, which showed that S wished to avoid the possibility of a considerable delay in reimbursement.
- The clause was therefore not a penalty and could be enforced by A.
- Regarding the guarantee, whilst the Court did not strictly need to decide the point because the clause was held to be enforceable, the Judge commented that a guarantee could not be used as an indirect way of invoking an otherwise unenforceable penalty clause, as that would be contrary to public policy.
Points to Note:
- This case reinforces the now quite well-established position that in relation to commercial contracts the Courts exercise very great caution before striking down a liquidated damages clause as a penalty. What is interesting in this decision is that the Court was prepared to uphold a liquidated damages provision which provided for a single lump sum payment irrespective of the extent of the breach. Previously these types of clauses have been most susceptible to challenge.
- The Court was willing to adopt a flexible, non-traditional approach towards the enforceability of a liquidated damages clause rather than adhering strictly to the classic principle of assessing genuine pre-estimate of loss versus penalty. It is potentially of equal or greater weight to evaluate whether the primary purpose of the clause is to act as a deterrent against breach.
- It is now extremely difficult to argue that a liquidated damages clause is a penalty and therefore unenforceable, when parties freely enter into a commercial contract, particularly where they have the benefit of legal advice during negotiations as they had done here.
- Nevertheless, if agreeing a liquidated damages provision it is always advisable to have some record of the commercial justification for any amount specified in the clause, in particular explaining why it is considered to be a genuine pre-estimate of loss. In addition, a provision is likely to be viewed more favourably if it provides some level of compensation in favour of both parties.