Liquidated damages are compensatory in nature, designed to compensate the injured party for the breach or failure in question. They are attractive as they avoid need for the injured party to prove actual loss resulting from breach. However, the amount of the liquidated damages payable under a liquidated damages clause must be a genuine pre-estimate of the anticipated loss resulting from breach, otherwise it will be unenforceable as a penalty clause. In assessing whether a clause is a penalty, courts also consider the “commercial justification” for the liquidated damages clause and whether the predominant purpose of the provision is intended to deter a breach rather than to protect the injured party’s commercial interests.
More recently, case law has highlighted a more expanded use of liquidated damages, which have strayed beyond the typical delay and performance damages.
For example, Azimut-Benetti SpA v Healey concerned an agreement to buy a €38 million yacht. The agreement contained a clause stipulating that if the yacht builder lawfully terminated the contract, it could keep 20% of the contract price as compensation for its estimated losses, but had to return the balance of sums received and the buyer’s installed supplies. Was this a penalty?
The court ruled that is was not. The court held that it must be careful not to set too stringent a standard and must bear in mind that what the parties have agreed during commercial negotiations, should normally be upheld. The purpose of the clause in question was not merely to act as a deterrent and was commercially justifiable as striking a balance between the parties on lawful termination by the yacht builder.
Practical advice when considering a liquidated damages clause:
- Is the amount of the damages a genuine pre-estimate of loss? This can be calculated beforehand and provided such calculation shows a clear and logical basis for the level of damages set, should be persuasive in the event of a dispute.
- Are the damages the same amount for different breaches or failures? If so, it may be difficult to demonstrate that such damages are not penalties.
- Are the damages sufficient to compensate the injured party? Note that liquidated damages usually also cap the amount of compensation payable for the breach and the injured party is unable to claim additional costs incurred over and above the contractually stipulated amount for liquidated damages.
- Would an alternative to liquidated damages be more appropriate? It is possible to draft contractual arrangements to provide for the same commercial effect as liquidated damages. In CMC Group PLC v Zhang the court held that a provision stipulating that on breach of a settlement agreement Mr Zhang should pay back the $40,000 paid to him under the settlement constituted a penalty. However that position would have been different if payment of the $40,000 had been construed to be conditional on Zhang’s observance of the terms of the settlement agreement.