The High Court has recently looked at issues arising where one party seeks to enforce a liquidated damages clause incorporated into a shipbuilding contract, and the defaulting party contends that liquidated damages are not payable because they constitute a “penalty”.

Facts

The claimant was a luxury yacht builder which agreed to construct and sell a super yacht to a special purpose company incorporated in the Isle of Man. The buyer’s liabilities were guaranteed by the defendant.

Under the termination clause within the contract it was agreed that, in the event of a default by the buyer, the builder was entitled to recover an amount equal to 20% of the contract price by way of liquidated damages and, subject to that retention, would then promptly return the balance of any sums paid by the buyer up to the date of termination.

The price for the super yacht was €38 million and, following the buyer’s default, the builder claimed liquidated damages of €7.6 million from the defendant under the guarantee. The defendant resisted this claim on the basis that the liquidated damages provision constituted an unenforceable penalty clause.

The builder denied that the liquidated damages clause constituted a penalty but also raised another argument. That, even if the liquidated damages did amount to an unenforceable penalty, the defendant was nonetheless liable under the guarantee on the basis of a provision stating that the guarantee would not be rendered unenforceable by reason of any “irregularity, illegality, unenforceability or invalidity” in the underlying construction contract.

Was the liquidated damages provision a penalty?

Mr Justice Blair reviewed the line of authorities discussing penalty clauses.

  • The essence of a liquidated damages clause is that it should represent a genuine pre-estimate of the loss that the innocent party will suffer upon the termination of the contract.
  • By contrast a penalty clause is one which provides for the payment of money from the defaulting party, the predominant contractual function of which is to deter a party from breaking the contract rather than to compensate the innocent party for any breach. The hallmark of a penalty clause is that it is designed to function as a deterrent rather than to provide compensation for a loss.
  • The question of whether an agreement to pay a specified sum is a penalty or an agreement to pay liquidated damages is a question of construction to be decided on the terms and the inherent circumstances of each particular contract judged at the time the contract was made and not at the time of the breach.
  • A court must be careful not to set too stringent a standard when determining whether a liquidated sum constitutes a penalty and should bear in mind the principle that, where commercial parties enter into a contract with equal bargaining power, the parties’ agreement should normally be upheld and great caution should be exercised before striking down a clause as penal.

Having considered the legal principles involved, Blair J looked at the pre-contractual negotiations between the parties and at the termination clause as a whole. He was influenced by the fact that the termination clause did not only provide for the payment of liquidated damages but also that, once the builder had retained 20% of the contract price, it was then obliged to immediately return any balance to the buyer.

In the absence of such a provision, the builder would be likely to retain all sums paid until its unliquidated damages claim had been resolved. This would lead to a potential delay before the buyer could receive repayment of any surplus between the recoverable losses due to the builder and the total sums paid under the shipbuilding contract.

For this reason, Blair J viewed the clause as seeking to strike a balance between the commercial interests of the parties in the event that the builder lawfully terminated the contract due to the buyer’s breach. He concluded that this commercial rationale for the liquidated damages provision was evidenced by the parties’ pre-contractual negotiations, which showed that the buyer wished to avoid the possibility of a considerable delay in reimbursement.

Blair J rejected the defendant’s submissions that the court must form a view as to whether the penalty clause was a genuine pre-estimate of loss by assessing the maximum possible loss that the parties could have expected to flow from any termination of the contract and the extent to which the liquidated damages figure exceeded that maximum possible loss. In rejecting that argument, Blair J was influenced by the fact that both parties had the benefit of legal representation during the contract negotiations and that the liquidated damages clause was freely entered into.

Comment

Blair J’s decision is particularly interesting in showing that the courts will uphold a clause of this nature without necessarily forming a view as to whether it represents a genuine pre-estimate of loss in order to decide whether the clause is a penalty. It is potentially of equal or greater weight, particularly if the parties are of equal bargaining power, to assess whether the primary purpose of the clause is to act as a deterrent.

If the liquidated damages provision was not enforceable, was the defendant still liable under the guarantee?

Although this issue did not need to be decided, given that Blair J concluded that the liquidated damages provision was enforceable, Blair J’s obiter view was that the guarantee would not respond to require the guarantor to pay the liquidated damages where the provision in the underlying contract was found to be unenforceable, notwithstanding the term that the guarantee would be enforceable regardless of any “irregularity, illegality, unenforceability or invalidity” in the underlying construction contract.

Blair J reached this conclusion on two bases. First, because a court strikes out a liquidated damages clause as a penalty as a matter of public policy. Second, that where a liquidated damages clause is struck out there is simply no obligation to pay any monetary sum which the guarantee can relate to. While this reasoning can be clearly understood where a specific clause is struck out, it is less clear, on Blair J’s analysis, what happens where the entire underlying contract is struck down.