Commercial Law Updates - An Analysis Of Cases And Developments From September 2010

Liquidated damages do not necessarily have to be a genuine pre-estimate of loss

AB is an Italian company which builds luxury yachts. It negotiated the sale of a yacht with Mr Healey. The price was €38million, payable by instalments. The contract was entered into with Shoreacres Limited, a company owned by Mr Healey, who entered into a personal guarantee in respect of the company's obligations. The contract included a liquidated damages clause which provided that on termination by AB, Shoreacres would pay an amount equal to 20% of the contract price as compensation for estimated losses and AB was to return the balance of sums received together with Shoreacres' supplies if not yet installed in the yacht. Shoreacres failed to pay the first instalment so AB eventually terminated and claimed under the liquidated damages clause. It sought summary judgment of sums due under Mr Healey's personal guarantee.

Mr Healey argued that the 20% was a penalty clause aimed at deterring breach which exceeded the maximum possible loss. 20% of the contract price payable cannot have been foreseen by the parties as conceivably representing AB's loss when the contract was entered into, especially as it was payable on the accounts of several events, some of which may have occasion serious and others trifling damage. In order for the court to determine whether it was a penalty clause, there would have to be extensive disclosure, so the matter was not suitable for summary judgment.

Much of the evidence concerned the negotiations over the termination clause. Although evidence related to negotiations, it was permitted as demonstrating that the reasons that the parties had for opting out of common law remedies constituted adequate justification for the discrepancy between the contractual measure of damages and that provided by the common law.

The evidence was muddied because negotiations had taken place in relation to two vessels with different purchasers, but with the same lawyers and agents on each side. In relation to the other vessel, Holman Fenwick, acting for AB, were repeatedly asked to reduce the percentage for liquidated damages fee to 10%. Holman Fenwick repeatedly refused (copying their reply to Shoosmiths and Shoreacres's agents), saying that 20% was a genuine preestimate of loss and that if 20% was not acceptable, then an alternative, more conventional model could be used instead, whereby AB would complete and sell the yacht to someone else and then account to Shoreacres for any excess remaining. Given the three year build period, this would extend the recovery period for Shoreacres considerably.

The Judge, Mr Justice Blair, granted summary judgement in favour of AB. He reviewed the authorities and in particular relied on a dictum in Cine Bes Filmcilik VE Yapimcilik v United International Pictures that a particular clause "might be commercially justifiable provided that its dominant purpose was not to deter the other party from breach". He went on to say that a Court has to be careful not to set too stringent a standard and bear in mind what the parties have agreed should normally be upheld. The purpose of the clause was to strike a balance between the interests of the parties, should AB lawfully terminate upon Shoreacres's breach – and here it was relevant that AB was also under an obligation, namely to return the balance of sums received, together with Shoreacres's supplies if not yet installed.

The dichotomy between a genuine pre-estimate of damages and a penalty does not necessarily cover all possibilities. There are clauses which may operate on breach but which fall into neither category, and they may be commercially perfectly justifiable, provided that their dominant purpose is not to deter the other party from breach. Here, the evidence of the discussions about the clause was relevant, including the offer of an alternative, and the stated advantage that the contract clause gave an immediate refund to Shoreacres (assuming Shoreacres had paid more than 20%). The Judge took the view that the evidence clearly showed that the purpose of the clause was not deterrent and that it was commercially justified as providing a balance between the parties. On that basis, there was no need for the Court to form a view as to the maximum loss which the parties would have expected to flow. The clause in question was not even arguably a penalty and was enforceable in accordance with its terms.

Two further points. First, Mr Healey had also argued that, because the 20% payment was a penalty, the obligations under his personal guarantee should also fall away. AB disputed this on the wording of the guarantee which stated that the liability of the guarantor was not to be "impaired, diminished, discharged or released by reason or in consequence of the illegality, unenforceability etc ... of the contract". The Judge agreed with Mr Healey's argument. A guarantor's liability need not be co-extensive with that of the principal debtor, but if the original obligation failed as a matter of public policy on the grounds that it was a penalty, then the same public policy would apply to recovery of the sum under the guarantee.

Secondly, Healey had argued that, because AB had elected to terminate and recover liquidated damages, it was precluded from seeking to recover the first instalment (which had fallen due before the contract was terminated), if the 20% was found to be unenforceable as a penalty. The Judge rejected this and stated that, if the liquidated damages had been found to be a penalty, AB could nonetheless have recovered the first instalment. He...