A recent case involving a breach of contract has put into doubt the black and white principles behind enforcing liquidated damages

Claims for liquidated damages start a lot of arguments, but the principles behind enforceability are considered to be black and white: if the sum claimed is a genuine pre-estimate of loss (or less than the actual loss), then it will be upheld; otherwise it is considered to be a penalty and will be struck down.

The recent decision in Azimut-Benetti vs Darrell Healey suggests, however, that things are not quite so simple after all.

The case involved a claim arising out of the breach of a contract for the construction and sale of a luxury yacht for €38m (£33m) to a company owned by Healey. The contract was based on Azimut’s standard form, which provided for instalment payments over several years and included a liquidated damages clause that would come into effect if the contract were terminated by Azimut.

In the event of termination for non-payment, Azimut was entitled to retain an amount from any payments made by the buyer, or to recover from the buyer an amount equal to 20% of the contract price. Subject to that retention, any excess sums would be returned to the buyer.

In negotiating its contracts, Azimut had taken the approach of offering this form of clause to replace the normal industry practice of retaining all sums paid by a buyer until the yacht was completed, sold and the losses could be calculated (which could be years later).

When the first instalment was not paid, Azimut terminated the contract and claimed against Healey, who had guaranteed the purchase, for the liquidated damages. Healey sought to have the clause struck out as a penalty because it could not represent a genuine pre-estimate of Azimut’s losses.

The commonly understood position with regard to the enforceability of liquidated damages was stated in 1915 in the case of Dunlop Pneumatic Tyre Co, which has often been understood to mean that it is an either-or proposition: if the sum payable under a liquidated damages clause is not a genuine pre-estimate of loss, it must automatically be a penalty.

Unfortunately for Healey, however, the judge did not think that things were so black and white. Some recent cases have suggested that there may be a class of liquidated damages clauses that falls between these two stools - and that they would be enforceable if they were “commercially justifiable” and their “dominant purpose” was not to deter a breach of contract.

Unfortunately for Healey, the judge did not think the rules on liquidated damages were so black and white

The judge felt that Azimut’s clause satisfied these tests and awarded it the damages. He said the clause was commercially justified because it fixed the allocation of risk between parties of equal bargaining power and it was not an entirely one-sided deterrent, because the buyer would not be kept out of its money (had any been due) for a long time.

The judge also considered whether Healey’s guarantee would have been effective had the underlying liquidated damages clause been invalid. The guarantee contained commonly used wording stating that liability would not be “impaired … by reason of the … unenforceability” of any part of the underlying contract. It was held that the clause could not be enforced if the underlying obligation was void at common law. Notwithstanding this decision, it is unlikely that these clauses will disappear from guarantees in the future.

A new category of liquidated damages clauses will be unwelcome to contractors, who are most commonly on the receiving end of such provisions. In defending a claim for liquidated damages, it will no longer be sufficient to argue that the clause is a penalty because the sums cannot (or do not) represent a genuine pre-estimate of the losses incurred.

This does not mean that employers are free to use clauses that are much more favourable to them; to be enforceable, they still have to pass the ill-defined tests of being “commercially justifiable” and the must not have a “dominant purpose” of deterring a breach of contract. For all that, the safest approach for both sides when calculating a liquidated damages figure to go into a contract remains using a genuine pre-estimate of loss.
Hugh Saunders is a solicitor in the construction group of Fladgate