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Liquidated Damages: The new approach of Commercial Justification

28 Jul 2017

Jan Rzedzian, an Associate Solicitor in our Construction Team, looks at the law on contractual penalties.

A century has now passed since the Dunlop case was first decided, and inevitably questions as to the continued applicability of the “Dunlop principles” in today’s modern commercial world have been asked. A chain of legal cases has shown that the courts have listened to those questions and are now prepared to take cognisance of the parties commercial interests when determining if a liquidated damages figure amounts to a penalty.

In the case of Lordsvale Finance plc v Bank of Zambia (1996) 3 WLR 688, the parties entered into various Loan Agreements in which Lordsvale loaned the Bank $230m. It was a term of the Agreement that if there was a default by the Bank, it would pay “default interest” at a rate to be determined by a formula, plus an additional unexplained 1%. The Bank defaulted and in the subsequent proceedings argued that the interest rate, particularly the additional unexplained 1%, was intended to deter a breach rather than compensate Lordsvale for loss and was consequently a penalty and unenforceable. The court looked at the commercial justification of the clause and concluded:

“There would therefore seem to be no reason in principle why a contractual provision the effect of which was to increase the consideration payable under an executory Contract upon the happening of a default should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, provided always that its dominant purpose was not to deter the other party from breach.”

Lordsvale was considered and approved by the Court of Appeal case of Cine Bes Filmcilik ve Yapimcilik v United International Pictures (2003) EWCA Civ 1669. This case concerned a Licence Agreement for the distribution of two films. A dispute arose regarding a termination payment which it was alleged amounted to a penalty. When deciding the case Lord Justice Mance said:

Jan-Rzedzian

“I have also found valuable Colman J’s further observations in Lordsvale…which indicate a 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 may be commercially perfectly justifiable.”

In Azimut-Benetti Spa v Healey (2010) EWHC 2234, the Court held that the liquidated damages figure of 20% of the purchase price of €38m, payable on termination of a Contract for a luxury yacht was not penal. The Court accepted the liquidated damages clause “objectively regarded…had a clear commercial and compensatory justification. The clause is plainly not a deterrent…”

If you have any queries in relation to the issues raised in this article, please contact Jan Rzedzian, Associate Solicitor in the Construction Team at Hay & Kilner

Call: 0191 232 8345

Email: Jan.Rzedzian@hay-kilner.co.uk