Genuine pre-estimates or penalties
Expanded use of liquidated damages
Damages for changes to key personnel
What to look out for
Alternative to liquidated damages
Liquidated damages are a fixed sum payable to an injured party to compensate it for a specified breach or failure. They are attractive as they need not be proven by the injured party. However, parties should be aware that liquidated damages also cap the amount of compensation payable for the breach or failure to which the liquidated damages apply. This sometimes comes as a surprise to employers and project sponsors where they find that they are unable to claim additional costs that have been incurred over and above the contractually stipulated amount for liquidated damages.
Liquidated damages are compensatory in nature – that is, they are designed to compensate the injured party for the breach or failure in question. Therefore, where they constitute a penalty, they will not be enforceable.
What constitutes a penalty has been the subject of a number of cases. It is often quoted during contract negotiations that liquidated damages must be a genuine pre-estimate of the loss that is likely to be suffered by the injured party as a consequence of the breach or failure; otherwise, they will be penalties and thus unenforceable. In essence:
"there must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered before it can be said that the agreed pre-estimate is unreasonable."(1)
The word 'genuine' in this context does not refer to whether the party that determined the pre-estimate did so genuinely or honestly. The issue here is whether the pre-estimate is set at a level that is compensatory rather than a deterrent.
However, the courts have developed their thinking beyond determining whether damages are simply a genuine pre-estimate of loss or a penalty. More recent authority indicates a new approach – determining the 'commercial justification' for the liquidated damages clause. Under this approach, the courts also look at the predominant purpose of the liquidated damages provision to ascertain whether it is intended to deter a breach or failure rather than to protect the injured party's commercial interests.
In recent years liquidated damages have strayed beyond the typical delay and performance damages; they also appear in provisions that on their face do not appear to be liquidated damages provisions at all. This is illustrated in Euro London Appointments Ltd v Classens International Ltd,(2) in which an employment agency's terms provided for a fee to be paid in the event of a successful introduction within seven days of the invoice. A proportion of that fee was refundable on a sliding scale, depending on how long the applicant was engaged. However, the right to obtain such a refund applied only if the fee was paid within the seven-day period following the invoice. It was claimed that the inability to recover a refund if this payment term was breached constituted a penalty and was therefore unenforceable. However, the Court of Appeal held that even if the inability to recover the refund for non-payment of the invoice within the seven-day period did not constitute a genuine pre-estimate of loss, the dominant purpose of this clause was not a deterrent and therefore there was no reason why this provision should not take effect. The court held that the dominant purpose of this clause was to incentivise payment of the introduction fee and therefore reduce the insolvency risk.
A number of other cases illustrate the use of liquidated damages beyond the traditional delay and performance damages.
Azimut-Benetti SpA v Healey(3) concerned an agreement to buy a €38 million yacht. This 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 uninstalled supplies. Was this a penalty?
The court ruled that it was not. The court must be careful not to set too stringent a standard and must bear in mind that what the parties have agreed should normally be upheld. At least in connection with commercial contracts, great caution should be exercised before striking down a clause as penal. A particular clause may be commercially justifiable, provided that its dominant purpose is not to deter the other party from breach. The purpose of the clause in question was not deterrent and was commercially justifiable as striking a balance between the parties on lawful termination by the yacht builder.
Talal El Makdessi v Cavendish Square Holdings BV(4) involved an agreement to purchase certain shares in a company by way of instalments. This share sale agreement also contained restrictive covenants. If the seller breached these restrictive covenants, it would not be entitled to the outstanding instalment payments and would be required to sell the remaining shares in the company at an undervalue. The seller breached its restrictive covenants, but successfully claimed (on appeal) that its inability to recover payment of the outstanding instalments and its obligation to sell the remaining shares to the purchaser at an undervalue constituted a penalty.
The purchaser of the shares claimed that this arrangement was commercially justified to protect it for the loss of the goodwill arising as a consequence of the seller's breach of the restrictive covenants. The Court of Appeal held not only that these provisions were not a genuine pre-estimate of loss, but also that they were not commercially justified. The primary reasoning was that the amount payable by the seller for such a breach was out of all proportion to the loss attributable to the breach.
The latest case dealing with an increasingly familiar additional use of liquidated damages is Bluewater Energy Services BV v Mercon Steel Structures BV.(5) This case involved a subcontract for an oilfield mooring system in the Caspian Sea. The subcontract provided for substantial liquidated damages in the event of unauthorised changes of key personnel. The subcontractor claimed that the liquidated damages clause was an uncommercial mechanism to restrain it from dealing with its personnel and, since there was no discernible loss, it was unenforceable – but was this right?
The court noted that cases in which agreed sums for liquidated damages were held to be a penalty are rare and emphasised that the subcontractor had to show that the liquidated damages clause was a penalty. This had to be done objectively by considering the position at the time that the contract was made. Key personnel on this and similar projects were central to successful performance of the contract, and the opportunity for the contractor to approve or disapprove the replacement of those personnel was therefore an important safeguard. If one of the key personnel was replaced without approval and the replacement was unsuitable, this could cause the project a great deal of disruption. It was impossible to put a precise figure on the damages, but the relevant sums needed to be assessed by people experienced in such projects, which they were.
In the context of this particular project, the court considered that the sums in question could not be described as unconscionable in terms of being extravagant or exorbitant when compared with the range of possible damages that could arise from such a breach, and that the subcontractor had not come close to demonstrating that the sums were penalties.
The following key questions should be borne in mind when considering liquidated damages provisions:
- Is the amount of the damages a genuine pre-estimate of loss? One way to assist in demonstrating this is to calculate the sum before the contract has been entered into. This calculation should show a clear and logical commercial basis for the amount of the damages and should be placed on file for future reference.
- 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? Certain losses may need to be excluded from the liquidated damages provision and therefore be unliquidated.
- Should an alternative to liquidated damages be used?
In some instances, contractual arrangements can be drafted to provide for the same commercial effect as liquidated damages. Such an approach can be preferable to liquidated damages, as it avoids any argument as to whether the amount payable is a penalty and therefore unenforceable. In some cases the courts have referred to this approach as a better option than liquidated damages. For example, in CMC Group PLC v Zhang(6) the court held that a provision stipulating that on breach of a settlement agreement Mr Zhang should pay back $40,000 paid to him under the settlement constituted a penalty, but that the 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.
Liquidated damages are undoubtedly useful. However, with the expansion of liquidated damages clauses beyond the traditional delay and performance failures, more issues will be raised as to whether these clauses are enforceable. Alternatives should therefore be considered to avoid potential challenges.
For further information on this topic please contact Chris Fellowes at Mayer Brown International LLP by telephone (+44 20 3130 3000), fax (+44 20 3130 3001) or email (firstname.lastname@example.org). The Mayer Brown International LLP website can be accessed at www.mayerbrown.com.
(1) Alfred McAlpine Capital Projects Ltd v Tilebox  EWHC 281 (TCC).
(2)  2 Lloyd's Rep 436;  EWCA Civ 385.
(3)  EWHC 2234 (Comm) (September 3 2010).
(4)  EWCA Civ 1539.
(5)  EWHC 2132 (TCC) (June 30 2014).
(6)  EWCA Civ 408.