Penalty clauses and liquidated damages: Traps for the ... - The Lawyer

equired the client to take a minimum of 500 consultancy days, was commercially justifiable, didnot amount to oppression and was negotiated freely - so was not a penalty.Take or pay clauses have generally been seen to give rise to a debt rather than a damages claim forbreach of contract, and for this reason it was commonly believed that the rule against penalties(which applies to specified sums payable upon a breach of contract) would not apply.Burton J stated in the E-Nik judgment that the client's failure to take the minimum number of daysgave rise to a debt rather than a damages claim, but he did not elaborate on why the rule againstpenalties could still be applied. It remains to be seen whether the courts will clarify this point infuture and whether take or pay clauses will continue to be subject to the rule against penalties.Is it justified?Recently, the courts have shown a consistent reluctance to interfere with commercial contractssigned by parties of broadly similar bargaining power.The difficulty of arguing that a clause is a penalty was highlighted by the case of Azimut-BenettiSpA (Benetti Division) v Darrell Marcus Healey (2010), where the High Court found that a clauseentitling a luxury yacht-builder to retain 20% of the purchase price of the yacht upon terminationfor late payment, was 'commercially justifiable' in the circumstances and therefore not a penalty.In Cavendish Square Holdings BV and another company v Makdessi (2012), the buyer purchased60% of the holdings in the world's largest advertising and marketing communications group, andhad an option to buy the remaining shares.Payment for the shares would be in three instalments, and if the seller breached certain restrictivecovenants this would cancel any outstanding instalments and trigger the option for the buyer topurchase the remaining shares at a discounted price (to reflect the impact of the breach on thevaluable goodwill of the target company).The seller breached the restrictive covenants, but argued that the buyer's right to cancel theoutstanding instalments and buy the remaining shares at a discounted rate amounted to a penalty.However, the High Court found that although the rule against penalties could apply under suchcircumstances, the terms were not penal for these key reasons:• there was a commercial justification for the terms• they were not extravagant or oppressive• the main purpose of the terms was to provide a clean break to the commercial relationshipand to adjust consideration for the remaining shares to reflect the loss in goodwill caused bythe breach• the terms were negotiated heavily by experienced solicitorsTips on how to make it less likely that your LD is deemed to bea penaltyAlthough each case is decided on its facts, there are a number of guiding principles to be taken intoaccount when drafting an LD clause, including:• avoid specifying sums payable upon breach which are so high that they cannot be seen ascommercially justifiable or a genuine pre-estimate of loss• different types of breach should generally attract payment of different sums in order to beregarded in each case as a genuine pre-estimate of loss• if the primary obligation is payment of a particular sum, then breach of this clause shouldnot usually give rise to a 'penalty' payment of a much higher sum