In order for liquidated damages to be enforceable and upheld by the courts, it is usually a requirement that they can be shown to be a 'genuine pre-estimate of loss', however a recent case shows a shift away from this approach.
Liquidated damages provisions may be found to be unenforceable by the courts where the damages specified are not a 'genuine pre-estimate of loss' but are considered 'penal'. A liquidated damages clause may be deemed a penalty if the sum stated "is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed [the breach of contract]." As a matter of public policy, a liquidated damages clause whose dominant purpose is to deter or intimidate a party against breaching a contract may be unenforceable.
The courts must decide whether a clause is an enforceable liquidated damages provision or a penalty based on the interpretation of the terms and conditions of each particular contract and the circumstances surrounding the contract at the time it is made, and not at the time that the breach of contract occurs.
A recent English High Court decision from September 2010 highlights the arguments a court will consider when deciding whether liquidated damages clauses are, in fact a penalty, and therefore, unenforceable. The facts of Azimut-Benetti SpA (Benetti Division) v Darrell Marcus Healey EWHC 2234 (Comm) were that Azimut, a luxury yacht builder in Italy, applied to court for an order seeking payment of liquidated damages. By a yacht construction contract, Azimut had agreed to construct a 60 meter yacht for an Isle of Man company (the "Buyer"). The purchase price was £38 million to be paid in installments over the course of three years. Mr Healey gave a personal guarantee of the Buyer's payment obligations under the contract. The contract provided that in the event of a late payment by the Buyer, Azimut could terminate the contract and retain (or recover) 20% of the contract price (€7.6 million) by way of liquidated damages. Azimut was obliged to return any other part of the contract price it had already received, where it chose to terminate the contract in this way.
The Buyer defaulted on a payment and Azimut subsequently terminated the contract and sought to exercise its rights against the Buyer for payment of liquidated damages. It simultaneously demanded payment from the guarantor, Mr Healey, under the guarantee. Mr Healey resisted payment under the...