Use LADs to Compensate (not Deter)

In order to avoid technical defences to an agreed level of damages (liquidated damages), you should concentrate on making sure the purpose of the clause is made really clear.

Compensation

In Lorsdvale v Zambia, the question whether the amount was a penalty or a genuine pre-estimate was based on:

“whether at the time the contract was entered into the predominant contractual function of the provision was to deter a party from breaking the contract or to compensate the innocent party for breach”

This view was upheld in Azimut-Benetti v Healey a case about the construction and sale of a super-yacht. The price as $38m with agreed damages set at 20% of that price in the event the contract was terminated.

Liquidated damages are not commonly used for termination provisions.  A more traditional clause would allow the yacht builder to complete the yacht, sell to a third party and sue for its un-recovered costs and losses.

After termination, the buyer argued that the yacht builder’s losses were far less than the 20%. An expert argued that it was not  ‘a reasonable or legitimate estimate of the loss [to be] suffered.

The court rejected any suggestion that it should form a view as to the maximum possible loss that might have flowed from the termination and compare it to the amount set out in the contract. The court upheld the amount saying:

“Both parties had the benefit of expert representation in the conclusion of the contract. The terms, including the liquidated damages clause, were freely entered into… in a commercial contract of this kind, what the parties have agreed should normally be upheld.”

Aim to compensate

Your agreed damages should be intended to compensate the innocent party, not punish or deter the wrong-doer.  That is the principle behind damages for breach of contract as well as the correct approach to LADs.

Cases: Lordsvale Finance Plc v Bank of Zambia [1996] QB 752, 762; Azimut-Benetti Spa (Benetti Division) v Healey [2010] EWHC 2234 (Comm)

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