UK: Liquidated Damages Or Penalty? Beware The Difference

Last Updated: 3 April 2011
Article by Russell Kelly

It is well established that a contractual clause providing for the payment by a defaulting party of a sum which is a genuine pre-estimate of loss is enforceable as liquidated damages while a clause which is predominantly to deter a party from breaking the contract is a penalty and thus unenforceable. The question of whether a sum stipulated is a penalty or liquidated damages is a question of construction and one has to consider all the relevant circumstances existing at the time that the contract was made (Dunlop Pneumatic Tyre Co Ltd v New Grange and Motor Co [1915]). A recent case before the English Commercial Court considered such a clause in a contract for the construction of a yacht.

The defendant in the matter (Azimut-Benetti SpA v Darrell Healey [2010] EWHC 2234) had given a personal guarantee for the obligations of the buyer, an Isle of Man special purpose company, under a contract with the Italian builder in relation to the construction of a 60 metre yacht for a price of €38 million, payable in instalments.

The yacht construction contract contained a clause entitling the builder to suspend construction of the yacht and/or terminate the contract at any time if the buyer failed to pay any sum due and owing under the contract within 45 days after the due date. The contract also provided that, upon lawful termination of the contract by the builder, the builder would be entitled to retain an amount equal to 20% of the contract price out of the payments made by the buyer or, if the buyer had not yet paid that amount, to recover this sum from the buyer. This amount represented liquidated damages as compensation for the builder's estimated losses (including agreed loss of profit). The clause also provided that, subject to that retention, the builder would promptly return the balance of sums received from the buyer, together with the buyer's supplies if not already installed in the yacht.

The buyer in fact failed to pay even the first instalment due under the contract and the builder terminated the contract and brought proceedings against the defendant under the guarantee to recover 20% of the contract price. The guarantor argued that the clause concerned was a penalty and accordingly unenforceable such that no liability could attach under the guarantee. He submitted that the liquidated damages figure of 20% of the purchase price (being €7.6 million) was not a genuine pre-estimate of the loss that the builder would suffer upon termination of the contract but was rather a penalty, designed simply to discourage the buyer from breaching the contract.

The court took the view that the relevant clause, taken as a whole, not only placed an obligation on the buyer (to pay the compensation) but also placed an obligation on the builder (promptly to return the balance of sums received from the buyer rather than retaining the funds until the losses were actually realised, which may have been many months later). The purpose of the clause was to strike, or seek to strike, a balance between the interest of the parties should the builder lawfully terminate upon the buyer's breach. There had been extensive pre-contractual exchanges during which the rationale for the clause had been explained and alternative provisions explored. The court found that these exchanges clearly showed that the purpose of the clause was not a deterrent and that it was commercially justifiable as providing a balance between the parties upon lawful termination by the builder. The builder had made it clear that the 20% figure was in fact the minimum that would realistically be suffered if they were required to resell the vessel should the buyer default. In addition to the costs of resale they would have the cost of borrowing the money from a bank and depreciation on the yacht due to its bespoke design for the buyer.

Both parties had had the benefit of legal representation in the conclusion of the contract and the terms of the contract were freely entered into. In the court's view the clause in question was not even arguably a penalty and it was therefore enforceable, as was the guarantee.

Whilst not every yacht or ship building contract will involve a guarantee for the buyer's obligations many will contain liquidated damages clauses such as that considered by the court in this case and the enforceability or otherwise of such clauses will depend upon the circumstances. As the court made clear however, in commercial contracts what the parties have agreed should normally be upheld unless there are compelling reasons to interfere.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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