Liquidated Damages in Shipbuilding Contract

Penalty or Liquidated Damages?

Liquidated damages are the predetermined estimate of loss to one party when the other party has delayed or failed to meet some contractual deadline or achieve certain performance criteria. Its purpose is to provide for adequate compensation to the Buyer while ensuring that the Seller is not unreasonably penalized.

In a typical shipbuilding contract, it is common to see liquidated damages clause for delay delivery. This will be computed on a time basis (daily, weekly or monthly) e.g. US$5000 per day of delays or based on a percentage of the contract e.g. 0.2% of the contract price for each day of delay etc. Usually, it will be capped at 10% of the contract price. The parties may agree to a grace period (of between 7 to 21 days) before the liquidated damages become operative.

Sample Text: “If the Vessel is not completed and delivered to the Buyer by the Contractual Delivery Date or the Revised Delivery Date then subject to the provisions of sub-clause (to be inserted) hereof, the Builder shall by way of agreed liquidated damages (not as a penalty) for loss of use of the Vessel pay to the Buyer the sum of $5,000 (five thousand US Dollars) per day or part-day of delay for the first 30 (thirty) days beyond the Contractual Delivery Date, the sum of $10,000 (ten thousand US Dollars) per day or part-day of delay for the next 30 (thirty) days beyond the Contractual Delivery Date and the sum of $15,000 (fifteen thousand US Dollars) per day or part-day of delay for the next 120 (one hundred and twenty) days beyond the Contractual Delivery Date.”

Key Points for Negotiation

This should include the rate, method (on monetary terms or percentage), time basis, (daily, weekly or monthly), grace period (if any), distinguishing between what constitutes permissible delays, the cap or limit of liability and nature of such remedy(exclusive or non-exclusive). Apart from delays, some shipbuilding contract will also provide for liquidated damages in the event of shortcomings during test and trials (insufficiency of speed, excessive fuel consumption, the inadequacy of deadweight capacity and bollard pull etc). In such cases, it is prudent to ensure that test and trial conditions are qualified.

Speed: In respect of speed, a well-crafted clause will indicate the trial conditions under which the main propulsion machinery should perform i.e. engines at the maximum continuous rating of a defined kW each at a specific speed and with the wind speed not exceeding agreed beaufort wind force and the draft at which the vessel should be.

Fuel Consumption: This should be measured on the test bed at 100% load, with the specification not to exceed certain g/kWh plus X% for each engine driven pump plus Y% tolerance (according to ISO standards). Fuel oil quality will be based on certain ISO standards. Parties will normally appoint Classification Society surveyor to attend such test bed trials and to certify the results.
  
Risk Allocation: In practice, shipbuilders would pass some of the liquidated damages on to appropriate vendors. But it will usually not extend to back to back pass through as these will be strongly resisted or will inevitably attract higher costs. A possible solution may be packaging various related equipment to the main vendor (as a consortium) with deeper pockets.

Q: Are such clauses enforceable?

A snap reply: yes and no. English contract law recognized that, if the parties agree that a party in breach of contract shall pay an unjustifiable amount in the event of a breach of contract, their agreement is to that extent unenforceable. The enforceability of such clauses in a contract will depend on whether it is construed by the court as a genuine pre-estimate of the loss or void as a penalty.

In the classic case of Dunlop Pneumatic Tyre Co Limited v New Garage and Motor Co Limited [1], Lord Dunedin sets out what a penalty clause is. At page 86, he said: “The essence of a penalty is a payment of monies stipulated as in terrorem of the offending party and the essence of liquidated damages is a genuine covenanted pre-estimate of damage.” He went on to state that the question whether a sum stipulated is penalty or liquidated damages is: (a) A question of construction to be decided upon the terms and inherent circumstances of each particular contract, (b) To be determined as at the time of the making of the contract, not as at the time of the breach and (c) Whether the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.

Q: Why should the Courts have a say if the quantum of liquidated damages was agreed between the parties?

In the case of Robophone Facilities v Blank [2], Diplock LJ made the following observations: “the rule of public policy that the court will not enforce a "penalty clause" so as to permit a party to a contract to recover in an action a sum greater than the measure of damages to which he would be entitled at common law is well established”.

In Murray v Leisureplay plc [3], it was also said that: “The penalty issue is one of considerable jurisprudential interest. English law is well-known for the respect which it gives to the sanctity of contact...does not in this particular field take the same laissez-faire approach that it takes to (for example) the question whether parties can agree to time limits for the performance of obligations which they subsequently find difficulty in meeting… .” per Lady Justice Arden in Murray v Leisureplay plc, para 29. (where Lord Justice Clarke while agreeing with Arden LJ and Buxton LJ that the appeal on the penalty issue should be allowed, nevertheless prefers the broader approach of Buxton LJ).
  
From the above and various cases [4], a sum will be construed as a penalty if:

It is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach
If the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid and
There is a presumption (but no more) that it is penalty when a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage.

[However, if the consequences of the breach are such as to make precise pre-estimation almost an impossibility, it does not follow that the sum cannot be a genuine pre-estimate of damage]

Why should one bother to have such a clause in their contract?

An often misunderstood concept is the need for a liquidated damages clause. The writer has seen well-meaning but ‘misguided’ people advising shipbuilders or vendors not to agree to any liquidated damages clause at all. This can only be attributed to want of relevant knowledge on its purpose. A liquidated damages clause is a double-edged sword. If there are no liquidated damages clause in the contract or if the clause is construed as a “penalty”, this does not mean that no damages will be payable. Instead, damages will be at large. Depending on the circumstances, the innocent party may treat the contract as terminated and claim for damages under usual common law principles instead.

Computation of liquidated damages quantum for delays

For shipbuilding, there seems to be no universal formula, but the choice seems to be between the “loss of use” method and the interest costs to the buyer (computed from the date of scheduled delivery until actual delivery.

Footnotes:

[1] Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co.Ltd [1915] AC 79,
[2] Robophone Facilities v Blank [1966] 1 WLR 1428

[3] Murray v Leisureplay plc [2005] All ER (D) 428 [2005] EWCA Civ 96.

[4] CMC Group Plc and others v Michael Zhang [2006] EWCA 408, , Alfred McAlpine Capital Projects v Tilebox [2005] EWHC 281 (TCC), Cine Bes Filmcilik ve Yapim Click v United International Pictures [2003] EWCA Civ 1699, Cenargo Ltd v Empresa Bazan de Construcciones Navales Militares S.A. (2002)EWCA Civ 524, Lordsvale Finance plc v Bank of Zambia [1996] QB 752, Workers Trust bank Ltd v Dofap Ltd [1993] AC 573, Philips Hong Kong v A-G of Hong Kong (1993) 61 BLR 49, Clydebank Engineering and Shipbuilding Company Limited v Don Jose Ramos Yzquierdo y Castenada [1905] AC 6.


David Seah © All rights reserved 2007

UPDATE:

For the UK Supreme Court ruling on "Penalty" in 2015 see...

Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67.



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