In order for liquidated damages to be enforceable and upheld by the courts, it is usually a requirement that they can be shown to be a 'genuine pre-estimate of loss', however a recent case shows a shift away from this approach.
Liquidated damages provisions may be found to be unenforceable by the courts where the damages specified are not a 'genuine pre-estimate of loss' but are considered 'penal'. A liquidated damages clause may be deemed a penalty if the sum stated "is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed [the breach of contract]." As a matter of public policy, a liquidated damages clause whose dominant purpose is to deter or intimidate a party against breaching a contract may be unenforceable.
The courts must decide whether a clause is an enforceable liquidated damages provision or a penalty based on the interpretation of the terms and conditions of each particular contract and the circumstances surrounding the contract at the time it is made, and not at the time that the breach of contract occurs.
A recent English High Court decision from September 2010 highlights the arguments a court will consider when deciding whether liquidated damages clauses are, in fact a penalty, and therefore, unenforceable. The facts of Azimut-Benetti SpA (Benetti Division) v Darrell Marcus Healey [2010]EWHC 2234 (Comm) were that Azimut, a luxury yacht builder in Italy, applied to court for an order seeking payment of liquidated damages. By a yacht construction contract, Azimut had agreed to construct a 60 meter yacht for an Isle of Man company (the "Buyer"). The purchase price was £38 million to be paid in installments over the course of three years. Mr Healey gave a personal guarantee of the Buyer's payment obligations under the contract. The contract provided that in the event of a late payment by the Buyer, Azimut could terminate the contract and retain (or recover) 20% of the contract price (€7.6 million) by way of liquidated damages. Azimut was obliged to return any other part of the contract price it had already received, where it chose to terminate the contract in this way.
The Buyer defaulted on a payment and Azimut subsequently terminated the contract and sought to exercise its rights against the Buyer for payment of liquidated damages. It simultaneously demanded payment from the guarantor, Mr Healey, under the guarantee. Mr Healey resisted payment under the guarantee, arguing that the liquidated damages clause was a penalty, not a genuine pre-estimate of loss and was designed to deter the Buyer from breaching the terms of the contract and, as such, the provision was unenforceable. Mr Healey argued that because he had raised the question of the liquidated damages clause being a penalty, the court was required to form a view as to whether the sum of liquidated damages in the contract were a genuine pre-estimate of Azimut's loss arising from breach of contract by the Buyer. He argued that the court could only form such a view after hearing detailed evidence from both sides.
The 2003 case of Cine Bes Filmcilik1 was applied, in which the Court of Appeal declared that a tension existed between a genuine pre-estimate of damages and a penalty and that these two categories or labels did not necessarily cover all possibilities that arise under a commercial contract. There are clauses which may operate on breach, but which do not fall into either category, but they may be perfectly commercially justifiable. In 2005, the Court of Appeal held in Murray v Leisureplay2, that a particular liquidated damages clause may be commercially justifiable, despite the fact that it was not a genuine pre-estimate of loss, provided that its dominant purpose was not to deter the other party from breach.
Azimut submitted that the evidence of the negotiations between the parties showed that the liquidated damages clause had a clear commercial and compensatory justification, and was not merely a liquidated damages
clause, but provided for a refund of payments to the Buyer on termination. As such it was not a penalty for breach. It may have been found to be a penalty had the buyer not been entitled to the difference between what it had paid to date by installments and the liquidated damages.
The Court held that the liquidated damages clause placed an obligation on the Buyer, but it also placed an obligation on Azimut, namely an obligation to "promptly return the balance of sums received from the Buyer together with the Buyer's supplies if not yet installed in the Yacht". The purpose of the clause was to strike, or seek to strike, a balance between the interests of the parties should Azimut lawfully terminate the contract for non-payment. The Court was also influenced by the commercial nature of the contract for which both parties had the benefit of legal representation. It decided that the contract terms, including the liquidated damages clause, were freely entered into. It ruled that in a commercial contract of this kind, what the parties have agreed should normally be upheld. The High Court found that it was not arguable that the clause was a penalty and gave judgment for the amount claimed by Azimut.
This decision shows the courts' willingness to uphold a liquidated damages clause in a commercial agreement negotiated by lawyers between parties of equal bargaining power. It is also an example of the courts explicitly deciding a penalty clause issue by reference to the "commercial justification test", under which a liquidated damages clause may be upheld, not as a genuine pre-estimate of loss, but on commercial grounds, provided always that its dominant purpose is not to deter a party from breach of contract. This test has been applied on a number of occasions in recent years and offers a more flexible and commercial approach to determining the enforceability of a liquidated damages clauses than the traditional genuine pre-estimate of loss versus a penalty arguments.
Footnotes
1 Cine Bes Filmcilik VE Yapimcilik v United International Pictures [2004] 1 C.L.C. 401
2 [2005] EWCA Civ 963
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.
