Legal Briefing

Latest on the liquidated damages v penalty debate

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Corporate and commercial | 01 November 2010

English law generally respects the sanctity of contract and the courts are reluctant to void terms just because they are onerous to one party. An important exception to this is penalty clauses.

Parties to a contract can agree to liquidated damages, a set sum to be paid by a party in the event of a breach. This allows an innocent party to recover any expenditure wasted on giving effect to a contract and provides recourse against a defaulting party. As a matter of public policy, courts can choose not to uphold any clause that stipulates an excessive pecuniary charge on a defaulting party; such a clause is deemed to be a penalty clause and, therefore, unenforceable.

In the recent Azimut-Benetti Spa (Benetti Division) v Healey [2010], the High Court explored the factors that can be taken into account when distinguishing a liquidated damages clause from a penalty clause. The court also considered, obiter, the effectiveness of a guarantee that purports to guarantee payment under an unenforceable penalty clause.

Facts

Azimut-Benetti SpA, a luxury yacht builder, entered into a written contract with Shoreacres Ltd to construct and deliver a yacht. Shoreacres was a company wholly owned by the defendant, Darius Marcus Healey. The price for the yacht was €38m payable in instalments. Healey provided a personal guarantee for the cost.

The contract provided Azimut-Benetti with the right to terminate if Shoreacres failed to pay any instalment due. The contract also contained the following clause:

‘16.3. Upon lawful termination of this contract by [Azimut-Benetti] it will be entitled to retain out of the payments made by [Shoreacres] and/or recover from [Shoreacres] an amount equal to 20% of the contract price by way of liquidated damages as compensation for its estimated losses (including agreed loss of profit), and subject to that retention [Azimut-Benetti] will promptly return the balance of sums received from the [Shoreacres] together with [Shoreacres’] supplies if not yet installed in the yacht.’

In addition, the contract included a term that the liability of Healey as guarantor, was not to be released as the result of any ‘irregularity, illegality, unenforceability or invalidity in whole or in part’ of the contract.

The contract negotiations between Azimut-Benetti and Healey had not included any express discussions about the clause at all. However, at the same time, separate negotiations were taking place between Azimut-Benetti and Healey’s representatives regarding the purchase of another similar yacht on behalf of a Russian buyer. In those negotiations there was substantial discussion about whether Azimut-Benetti’s entitlement to liquidated damages should be reduced to 10%, as the Russian buyer considered 20% excessive. Azimut-Benetti refused and set out its commercial reasoning in writing, detailing why 20% was a genuine pre-estimate of the loss and highlighting the fact that the clause was compensatory to both parties given that the purchaser would be immediately refunded any amount paid over 20%. Azimut-Benetti also offered an alternative clause whereby it would complete and sell the yacht, realise its actual loss, and then account back to the purchaser for any excess remaining. However, it pointed out that this might involve delay in being refunded any money, especially if a dispute arose.

The contract with Shoreacres had to be concluded within a shorter timescale and so was completed while discussions continued regarding the purchase by the Russian buyer. It was agreed prior to completion that the same basic draft contract would be used for both transactions.

Shoreacres defaulted on the first instalment of the purchase price and, as a result, Azimut-Benetti terminated the contract and requested 20% of the contract price minus the deposit paid, totalling €7.1m. Azimut-Benetti pursued Healey for payment under the guarantee.

Arguments

Azimut-Benetti submitted that Healey had no real prospect of successfully defending the claim because the clause was a genuine liquidated damages clause. It sought to use the written evidence of negotiations with the Russian buyer to demonstrate that at the time of contracting, the clause was a genuine pre-estimate of loss, and that the clause was freely and commercially negotiated between the parties. Azimut-Benetti argued that since both contracts had been carried out ‘in tandem’ and both purchasers used the same representatives, negotiations with the Russian buyer could effectively be transposed on to the contract with Healey. Alternatively, it argued that even if the clause was unenforceable, Healey was liable as guarantor under the guarantee.

Healey resisted the application on the basis that the clause was a penalty clause and that extensive evidence would need to be adduced at trial to prove this. In addition, Healey argued that as the clause was a penalty clause and unenforceable, there was no liability on which the guarantee could fasten.

Decision

Although Blair J refused to give any detailed analysis on the evidence (as he deemed this was inappropriate at a summary judgment hearing), he found the evidence relating to the separate negotiations admissible and relevant, relying on the findings of Arden LJ in Murray v Leisureplay plc [2005]:

‘The court is not confined to the terms of the agreement and may look at the inherent circumstances of each particular contract, judged at the time of the contract, not at the time of the breach.’

The judge held that the evidence was relevant in so far as it demonstrated the reasons Azimut-Benetti had for including the clause at the time of contracting. However, it was not admissible as evidence of commercial negotiations with Healey, because matters in one negotiation could not be transposed onto another as this would require ‘the court to read too much into the evidence’.

On the enforceability of the clause, the judge found that statements by the parties that the clause was, or was not, a penalty, did not advance matters. However, Blair J concluded that the issue of whether 20% was a genuine pre-estimate of damage did not justify a trial. He instead adopted the ‘commercial justification test’ from Murray in that ‘a clause may be commercially justifiable provided that its dominant purpose is not to deter the other party from breach’. In view of this, the judge took into consideration the commercial reasons outlined in the exchange of negotiations between Azimut-Benetti and the Russian buyer.

Looking at the clause as a whole and not just the figure of 20%, the judge agreed with Azimut-Benetti and found that the dominant purpose of the clause was not to deter breach of contract but ‘was to strike… a balance between the interests of the parties should [Azimut-Benetti] lawfully terminate’. Healey would be refunded any money paid over 20% immediately, avoiding the inevitable delay that would have ensued had a conventional remedy been agreed, and Azimut-Benetti would have immediate funds to offset any losses.

Thus, agreeing with Azimut-Benetti’s justifications for the clause, the judge stated that because the clause had a clear commercial and compensatory justification for both parties, it was not a penalty and was, therefore, enforceable. The judge noted generally that where both parties are legally represented and the contract had been freely entered into, the court should uphold the terms the parties have agreed to, where possible.

The judge commented, obiter, that a guarantee could not be used as an indirect way of enforcing an otherwise unenforceable penalty clause. Specifically, in relation to Azimut-Benetti, Blair J noted that if the clause had been unenforceable, there would be no liability on to which the guarantee would attach. More generally, he said that such a construction would be contrary to public policy.

Conclusion

Azimut-Benetti demonstrates that in a commercial contract, the courts are increasingly willing to adopt a flexible approach towards interpreting liquidated damages clauses rather than adhering strictly to the classic principle of genuine pre-estimate of loss versus penalty.

Although the judge’s comments on the applicability of guarantees were obiter, Azimut-Benetti highlights the potential limitations of a guarantee where terms of the contract cease to be enforceable.

Some practical tips to bear in mind when drafting or negotiating a liquidated damages clause are set out below:

  • parties would be wise to record, in writing, reasonable justification for any amount specified in a liquidated damages clause, in particular explaining why it is a genuine pre-estimate of loss;
  • consider whether an alternative provision may be available;
  • a provision that provides some sort of compensation to both parties is likely to be viewed more favourably;
  • retain records of all negotiations; and
  • points raised during negotiation of similar or related contracts may also be relevant to some extent.