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Is it a penalty? Is it a liquidated damages clause? No, it’s “commercially justifiable”
01 February 2011

A liquidated damages clause is a provision often included in an agreement to ensure that the contracting parties can be adequately compensated in the event of termination of the contract. Such clauses are generally enforceable, provided they are based on a genuine pre-estimate of loss and are not intended purely to deter a party from breaching the contract.

In the recent High Court case of Azimut-Benetti SpA (Benetti Division) v Healey, the claimant contracted with Shoreacres Limited, owned wholly by the defendant, for the construction of a yacht for which the contract price including production and delivery was €38 million. Shoreacres agreed to pay by way of a number of instalments and Mr Healey personally guaranteed Shoreacre’s obligation to pay. An initial deposit of €500,000 was paid by Shoreacres, who then failed to pay the first instalment due. A clause within the contract permitted the claimant to terminate the contract in the event that Shoreacres failed to pay any sum owing within 45 days after the due date. In addition to this right, the clause stipulated that the claimant was entitled to retain or recover 20% of the contract price by way of liquidated damagesas compensation for its estimated losses, on the basis that if the contract were terminated the claimant would return the balance of any sums received in excess of 20%.

The claimant sought to rely on this clause following termination of the contract for Shoreacre’s failure to pay the first instalment. In subsequent court proceedings the defendant argued that the clause was a penalty and therefore unenforceable. The issue for the court to decide was whether the clause could be recognised as a liquidated damages clause, or whether it was in fact a penalty clause. By contrast to a liquidated damages clause, where a clause is considered to be merely punitive and its purpose is merely to deter a party from breaching the contract, it will be deemed a penalty clause and as such is unenforceable.

The court found that the clause was not a penalty, as its purpose was not a deterrent to termination of the contract, nor did the clause fall into the liquidated damages category as a genuine pre-estimate of loss. The clause was held to be enforceable on the basis that it was commercially justifiable, as it had been designed to strike a balance between the rights of the parties in the event that the claimant terminated the contract. Of significance was the fact that both parties had been legally advised, and there had been specific discussions regarding whether the parties should agree to a liquidated damages clause fixed at 10% or 20% of the contract price.

This case demonstrates that even where a liquidated damages clause is not based on a genuine pre-estimate of loss, it may not be deemed a penalty and may well be enforceable if the court considers it to be commercially justifiable. All facts considered, the court will generally uphold terms of a commercial agreement where the contract has been freely entered into and the parties are of equal bargaining power. 

For more information about this case or to find out more about how the Dispute Resolution team can help you please contact Ally Tow on 0118 952 7206 or email [email protected].

Consistent with our policy when giving comment and advice on a non-specific basis, we cannot assume legal responsibility for the accuracy of any particular statement. In the case of specific problems we recommend that professional advice be sought.

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