UK: Putting You On Notice: Penalties May Not Be Enforceable

Last Updated: 30 June 2009
Article by Richard Mabane

Lloyd's List, 20 May 2009

In a case involving late redelivery of a bulker, the tribunal took the view that the amount payable under a penalty was "unconscionable" writes Richard Mabane.

When is a penalty not a penalty? When it is a genuine pre-estimate of the loss recoverable in law, confirmed the English Court in an interesting recent late redelivery case (Lansat Shipping Co v Glencore Grain BV 2009 EWCH 551 Comm).

The vessel, a handysize bulker, had been chartered for three to five months at $29,500 daily. Additional clause 101 stated: "The charterers hereby undertake the obligation/responsibility to make thorough investigations and every arrangement in order to ensure that the last voyage of this charter will in no way exceed the maximum period under this charter party. If, however, the charterers fail to comply with this obligation and the last voyage will exceed the maximum period, should the market rise above the charter party rate in the meantime, it is hereby agreed that the charter hire will be adjusted to reflect the prevailing market level from the 30th day prior to the maximum period date until actual redelivery of the vessel to the owners."

Following redelivery 6.166 days late, the shipowner claimed $471,603.32, based on a market rate of $46,083.82 and applying that rate, not just to the period of 'overrun', but also to the previous 30 days.

English law has long distinguished between 'liquidated damages', which are recoverable because a genuine pre-estimate of the innocent party's potential losses, and a 'penalty', which is unenforceable because it is intended more as a deterrent and not a genuine pre-estimate of those losses.

The courts are not too stringent, and try to uphold the intended bargain, but if it is not a genuine pre-estimate of loss, the clause should not be upheld.

The case here involved late redelivery, where it is also settled law that, if an order is followed for an 'illegitimate' last voyage (i.e. one which cannot be expected to complete within the charter period), hire is payable at the charter rate up to the end of the maximum charter period and at the prevailing market rate only thereafter.

The owners conceded that a requirement for 30 days of extra hire for late redelivery alone would be a penalty, but argued that the clause here provided compensation for the owners' compliance with an illegitimate last voyage order, rather than lateness as such, and was therefore not a penalty.

On that basis, they argued:

1. The loss to be considered involved comparing the owners' position if the order had not been given, which meant assuming redelivery of the vessel at the time of the order; and,

2. Viewed that way, 30 days was a genuine pre-estimate of loss, and indeed, since 60 days was a typical voyage length for a vessel of this kind, represented a sensible mid-position in the range of losses that the owners might suffer.

The charterers argued that the extra hire was simply compensation for late redelivery, but that, even if the owners' interpretation was accepted, the position was no different: an illegitimate last order, if followed, gave rise to the same claimable loss as with late redelivery generally, namely the charter rate up to the maximum date and the market rate thereafter. The charterers further suggested that the clause could also apply to the consequences of legitimate last voyage orders, on the basis that the standard applicable ("thorough investigations", "every arrangement") meant that the charterers' reasonable expectations may not suffice, and the main obligation — to ensure that redelivery was not late — was one which could be breached regardless of whether the order had been legitimate.

The court rejected the owners' characterisation of the clause, pointing to the fact that loss only flowed from an illegitimate last order if the order was followed; and that, if the order was persisted in and the owners brought the contract to an end, they would suffer no loss at all by re-chartering at current market rates.

Like the arbitrators, the court also felt that the primary purpose of the clause was to deter charterers from redelivering late, rather than to compensate owners as such, approving the tribunal's view that the amount payable was "unconscionable" (unreasonably excessive), and citing the tribunal's example that the owners could have claimed $471,602.32 here even if redelivery had been only one hour late.

The decision demonstrates the risks of falling foul of the law in this area, even where good commercial reasons exist for the intended bargain.

On one view here, the clause could be seen as intending to compensate the owners for erring on the cautious side in following what turned out to be illegitimate final orders, in the absence of special knowledge (which charterers might have) of likely waiting, loading and discharging times which might otherwise enable them to reject the orders. Seen in that light, the provision might be considered a reasonable commercial carve-out, compensating the owners for allowing the charterers the benefit of the doubt and the much-improved market but, if the voyage did over-run, putting the owners nearer the financial position they could have been in if they had been able fully to assess the orders and (assuming no alternative orders) legitimately terminated the charter.

That said, even if a clause seems commercially reasonable, the guiding principles must not be forgotten. In particular, as this case makes clear, attention should be paid to amounts recoverable in law. Whilst English law recognises the concept of restitutionary damages (i.e. damages intended to reflect the benefit of non-performance to the party in breach), damages are generally based on the loss suffered by the innocent party and, in the area of late redelivery of ships, involve payment at the charter rate up to the end of the maximum period. The cases in this area, which could have developed differently, have referred in that regard to the owners' "expectation interest", i.e. anticipation that they would only receive the charter rate up to the last permissible date. What is ultimately recoverable in law may also involve subtle issues of interpretation and causation: here, the fact that illegitimate orders would not necessarily result in loss, depending how the owners and the charterers then behaved, made the owners' attempt to distinguish the clause as compensating for the owners' compliance with an illegitimate order (rather than the resulting lateness) more difficult to make good.

In assessing whether clauses are likely to be be upheld, rather than void as penalties, attention should also be paid to how the clause works in various permutations. In theory, a clause can validly provide for payment of an amount that reflects the upper end of the scale of possible losses. However, while the harshness of that result on the party in breach is not strictly speaking a determinative factor, potentially disproportionate effects will not assist a clause in being upheld. The example here of a one hour over-run is a case in point. A more flexible formula, possibly involving a sliding scale, might have avoided anomalies of this kind.

Last but not least, the precise wording can be important, even as a matter of appearance. Here, the arbitrators found the clause to be a deterrent partly because of its emphasis on the charterers' obligations ("thorough ensure ..the last voyage.. in no way exceed the maximum period..."), but might have found differently had the wording been less forceful.

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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