“Genuine Commercial Justification”

as a basis for a liquidated damages clause in Shipbuilding

Facts: XYZ Company signed a contract with the claimant shipbuilder for the construction of a luxury yacht. The contract price of €38 million was payable by installments over the course of three years, the first of which was due on 17 October 2008. Clause 16.1 (a) of the contract provided that the shipbuilder could terminate the contract if “the Buyer fails to pay any sum due and owing under this contract within forty-five days after the due date.” Clause 16.3 of the contract provided that “the Builder will be entitled to retain out of the payments made by the Buyer and/or recover from the Buyer an amount equal to 20% of the Contract Price (€7.6 million) by way of liquidated damages as compensation for its estimated losses (including agreed loss of profit).” The Buyer also personally guaranteed the payments under the contract.

In evidence it was shown that the liquidated damages clause was a standard provision in the shipbuilder’s contracts. If the clause was challenged, prospective customers would be offered a more traditional method of recovery whereby the shipbuilder would retain all installments paid by the customer until the shipbuilder was able to sell the yacht and recoup its losses. Only at the point of sale would the customer receive a refund for any excess already paid. By contrast, the liquidated damages clause offered a more immediate remedy to both parties as it allowed the shipbuilder to recover its losses straight away and provided that customers would be refunded any monies paid over and above the 20% amount.

XYZ Company defaulted on the first installment due on 17 October 2008. Over a substantial period of time, the shipbuilder tried to recover its monies but to no avail, so finally on 22 January 2010, it exercised its rights under clause 16.3 and claimed the amount of €7.1 million (minus a prepaid deposit of €500,000) from the Buyer. The shipbuilder also made a claim for payment under Buyer’s guarantee. XYZ Company refused to pay the sum demanded so the shipbuilder sought summary judgment against him. The Buyer resisted the application claiming that clause 16.3 was a penalty and not a genuine pre-estimate of the shipbuilder’s loss and argued that neither the company (pursuant to Clause 16.3) nor he personally (pursuant to the guarantee) was liable.

Decision: The High Court granted summary judgment in favor of the shipbuilder and ordered the Buyer to pay the sum demanded pursuant to clause 16.3. In its decision, the court stated that even for summary judgment a party seeking to overturn a liquidated damages claim had to do more than “merely assert” that such a clause was a penalty – evidence was needed. In this case a full trial was not required to establish whether the clause was a penalty or what the potential losses would be to the party seeking to rely on the clause. Instead the court relied on the cases of Cine Bes Filmcilick and Murray v Leisureplay to state that a liquidated damages clause might be justifiable where there is a ‘genuine commercial justification’ for such a provision as long as the main objective of the provision was not to deter the other party from breach.

Here the court found that on the evidence, the main objective of clause 16.3 was not to deter the purchaser from breach but rather it was clear that there was a ‘commercial justification’ for the inclusion of such a provision (namely to allow the shipbuilder to recover its losses in the event that the purchaser defaulted on its payment obligations). The court also noted that the purchaser had been offered the alternative, more traditional method of recovery but chose not to accept this.

Key Messages: The decision demonstrates the court’s willingness to uphold a liquidated damages clause where it has been negotiated by parties of equal bargaining power and where it is found that there is a ‘commercial justification’ for the inclusion of such a remedy. However, it is still important for a party wishing to rely on such a clause to document how it has calculated the amount payable by way of liquidated damages as notwithstanding this decision, the court will generally still look to determine whether the sum calculated is a ‘genuine pre-estimate of loss’. Finally if you are considering the inclusion of a liquidated damages provision in a contract during negotiations, it is worth considering whether an alternative remedy to liquidated damages can be offered, as in this case this appeared to be an important factor to the court in upholding the ‘commercial justification’ of clause 16.3.

Source: Bird & Bird