Liquidated damages cannot be claimed indefinitely
MSC MEDITERRANEAN SHIPPING v COTTONEX ANSTALT [2015]
This decision considered how long a party could claim liquidated damages following a serious breach of contract rather than choosing to end the contract and claim its actual loss as damages.
Facts:
- MSC Mediterranean Shipping (MSC) contracted with Cottonex Anstalt (C) to carry cotton by sea to Bangladesh in MSC’s containers.
- C sold the cotton to a company in Bangladesh (R). R never collected the goods even though it had paid for some of them and ownership in those goods had passed to R. C could not therefore unpack the containers (partly because of the involvement of the local customs authority) and consequently was unable to return them to MSC. This meant it was in breach of its contract with MSC.
- The contract contained what was considered to be a liquidated damages clause which provided for a fee to be paid to MSC for each day that the containers were not returned following delivery.
- There came a point at which there was no realistic prospect that C would be able to return the containers to MSC.
- A dispute arose as to whether C was liable to pay MSC the daily charge because the containers were still being used to hold the goods and for how long it had to pay that charge. By the time of the trial, the liquidated damages were US$1 million and this sum was rising each day.
Liquidated damages:
Liquidated damages are a fixed or determined sum agreed by the contracting parties to be payable if one of the parties defaults. There are limited circumstances where the Courts will intervene if a liquidated damages clause is deemed to constitute a penalty and, where the parties are both commercial entities, it is comparatively rare for the Courts to do this.Decision:
- The Court found that MSC had no ‘legitimate interest’ in keeping the contract alive once it became clear C was not going to be able to return the containers. Crucially and unusually, there was no evidence that MSC was suffering any ongoing loss of revenue. MSC had a surplus of containers and if it needed more it would simply go out and buy others. Once C had no real chance of being in a position to return the containers, it was considered to be in repudiatory breach (which means a sufficiently serious breach of contract that goes to the ‘root of the contract’ or where there is a demonstration of an intention not to be bound by the agreement in the future). It was concluded that MSC should be forced to accept the breach and bring the contract to an end.
- As C was unable to force R to collect the goods and return the containers to MSC, it was left with a potentially open-ended liability for liquidated damages. MSC was not seemingly suffering any loss as a result of C’s breach of contract, so the Court considered it was “wholly unreasonable” for it to continue to claim liquidated damages because it had not been allowing the contract to continue in order to “invoke the liquidated damages clause for a proper purpose but in effect, to seek to generate an unending stream of free income”.
- MSC’s claim for liquidated damages was therefore effectively capped at the date when C was treated as being in repudiatory breach.
- There is generally no duty to mitigate in respect of a claim for liquidated damages. Although the Court noted that it was reasonable to expect that if the containers had ever been required for new business, MSC would have bought additional containers in order to mitigate its loss, the judgment seemed to suggest this was not a legal obligation.
- The Court said that an express contractual discretion must be exercised in good faith and not arbitrarily, capriciously or irrationally in the absence of very clear contrary language. This principle applied to the decision as to whether to terminate an agreement in response to a serious breach, even though this right arises at common law rather than in accordance with the contract. It commented that how the right arises should not make any difference and that the exercise of an option to terminate the contract and previous cases dealing with how to apply a contractual discretion are both concerned with materially identical questions and essentially the same test applies.
Points to note:
- An injured party may only continue with an agreement where there has been a serious breach, if it has a legitimate interest in doing so - in this context, that was for as long as there was a realistic prospect C would be able to perform its contractual obligations. The daily rate in this respect was not found to be penal. However, once it became clear C would not be able to carry out those obligations, MSC no longer had a valid claim to the liquidated damages as it was not suffering any loss despite C being in breach.
- The Court provided a useful summary of the key principles applied to liquidated damages clauses from El Makdessi v Cavendish Square Holdings [2013] (although note some of these have changed following the appeal of that case to the Supreme Court - see here):
- a penalty is a sum of money to be payable upon a breach of the contract which is primarily intended to deter breach and secure performance of the contract;
- the question as to whether a sum is a penalty is one of construction of the contract, to be determined objectively when the contract was made;
- the burden is on the party who alleges that a payment is a penalty to show that it is one and great caution should be exercised before finding that a commercial contract clause amounts to a penalty;
- a sum is not a penalty:
- if it is a genuine pre-estimate of the loss which may be caused by a breach of the contract; or
- just because it is payable in a variety of circumstances, in some of which it will or may exceed the loss caused by the breach;
- however, if the sum is extravagant and out of all proportion to the loss likely to be incurred, in many cases, this may indicate that it is a penalty;
- even if a payment is not a genuine pre-estimate of loss, it will not be regarded as a penalty if it can be commercially justified, such as knowing with certainty in advance the financial consequences of a breach and recognising the importance of avoiding disputes;
- ultimately, the essential question is whether the payment provision is ‘unconscionable’ because it provides for a payment which is extravagantly high in comparison with the sum that would be required to compensate for the loss caused by the breach, and does so without sufficient commercial justification.
- The judge’s comments seem to confirm that if a decision to continue with a contract despite a breach would be “wholly unreasonable”, then that decision might be considered not to have been taken in good faith.
- Update 2016: The Court of Appeal upheld the original decision of the High Court judgment in 2016 - see our report in a case update.