The Penalty Principle

Market participants who regularly deal with contracts for the sale and purchase of new and used aircraft will be familiar with penalty clauses.

AIRCRAFT Purchase Agreements (APA's) routinely provide for a "nonrefundable deposit" to be paid by the buyer into escrow at the outset of the APA and for the APA to provide that, in the event of its termination due to buyer default, the seller will be entitled to be paid the deposit. Many APAs acknowledge that the deposit is paid to the seller as liquidated damages and not as penalty. This acknowledgement is important (but not conclusive) because penalty clauses are unenforceable whereas liquidated damages clauses are generally regarded as being enforceable under English law.

The Cavendish Decision

In Cavendish Square Holding CV v Makdessi [2015] UKSC 67, the Supreme Court set out a new test under English law for what constitutes a penalty, and indicated that in circumstances where there is equality of bargaining power and the parties have been advised professionally, the courts should be reluctant to decline to enforce a clause on the grounds that it is a penalty.

Although the Cavendish case related to a share purchase agreement, the principles laid down by the Supreme Court are relevant in relation to APAs, namely:

Well-advised commercial parties.

Where clauses have been negotiated between well-advised commercial parties this would raise a presumption that they had understood what they were agreeing to as regards the consequences of breach.

Deterrent must not be punitive.

A clause that seeks to deter breach so as to protect a legitimate interest will not necessarily be a penalty clause, so long as its effect is not punitive. The effect will be punitive if it is grossly disproportionate and/or unconscionable in comparison to the innocent party’s interest in enforcing the contract.

Wider commercial concerns.

Compensation for breach is not the only legitimate interest. Wider commercial concerns can be taken into account.

Secondary Obligations.

The law of penalties should apply to secondary obligations only. Typically, these are obligations that take effect to provide for a remedy in the event of breach of a primary obligation. In an APA context, this would include the secondary obligation of the buyer paying liquidated damages equal to an escrowed deposit in the event of its failure to pay the purchase price on delivery.

“Compensation for breach is not the only legitimate interest.”

Genuine Pre-estimate of Loss

As the law stood prior to the Cavendish decision, a clause in an APA designed more to deter a buyer from breaching an APA rather than to act as a genuine pre-estimate of the seller's loss would be held to be a penalty clause and unenforceable. Clauses providing for extravagantly large payments in comparison with the greatest loss that could arise, or clauses that could operate on a number of different breaches of varying severity, were liable to be considered penalties. As a result of the Cavendish decision, there is now more scope for arguing the wider commercial justifications for clauses that previously would have been considered to be penalties because they were primarily a deterrent to breach, rather than a genuine pre-estimate of loss.

Tandrin Aviation v Aero Toy Store

The law prior to Cavendish is well illustrated in the case of Tandrin Aviation Holdings Limited v Aero Toy Store LLC (2010) EWHC 40, in which Tandrin agreed to sell a Bombardier 605 aircraft to Aero Toy Store for US$31.75m. Tandrin was not the owner of the aircraft but had itself agreed to purchase the aircraft for US$26.5m from JetCoast 6051 LLC. At the time of signing the APA with Aero Toy Store, the aircraft was still in build at Bombardier. Under the APA, Aero Toy Store paid a US$3m deposit into escrow. The escrow agent was Insured Aircraft Title Service, Inc. (IATS). The Deposit and the balance of the purchase price (US$28.75m) were to be paid to Tandrin (via IATS) on delivery.

The APA provided that on its termination as a result of default by Aero Toy Store, IATS would pay the US$3m Deposit to Tandrin as liquidated damages (and Aero Toy Store would promptly give instructions to IATS to that effect). The parties acknowledged that such liquidated damages were a "reasonable estimate of the damages that would be incurred by [Tandrin]" in the event of Aero Toy Store's default and that Tandrin's right to receive the US$3m would be Tandrin's sole remedy in that event. Prior to delivery of the new aircraft by Bombardier, Aero Toy Store failed to participate in the pre-delivery inspection having already told Tandrin that it would walk away from the deal as prices of aircraft had fallen sharply as a result of the financial crisis.

Tandrin took delivery of the aircraft from JetCoast and in turn tendered it for delivery to Aero Toy Store. Aero Toy Store failed to accept delivery of the aircraft or pay the balance of the purchase price to IATS. Tandrin terminated the APA on the grounds of Aero Toy Store's breach, the consequence of which was that the Deposit became payable to Tandrin as liquidated damages. Aero Toy Store further breached the APA in refusing to instruct IATS to release the Deposit to Tandrin.

Tandrin sued Aero Toy Store. Aero Toy Store defended the claim on the basis that the provisions of the APA allowing Tandrin to retain the Deposit amounted to a penalty.

The Law pre-Cavendish

When the Tandrin case was heard in 2010, the law in England as to whether a sum stipulated for in a contract is a penalty or liquidated damages was set out in Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Limited [1915] AC 79,

in which the House of Lords set out three principles:

1. It does not matter if the clause describes the payment as a penalty or liquidated damages. The Court will determine whether the payment stipulated is in truth a penalty or liquidated damages.

2. Payment in terrorem vs genuine pre-estimate of loss. The essence of a penalty is a payment of money stipulated by way of threat or intimidation of the other party to the contract; the essence of liquidated damages is a genuine covenanted pre-estimate of loss.

3. Each case decided on its own facts. The question whether a sum payable is a penalty or liquidated damages is a question of construction to be decided upon the terms and circumstances of each particular contract.

The Dunlop case set out a number of tests to be used to ascertain whether a sum payable under a contract would

amount to an unenforceable penalty or an enforceable obligation to pay liquidated damages.

In finding that Tandrin was entitled to be paid the US$3m Deposit, the judge in the Tandrin case applied these tests as follows:

1. Extravagant and unconscionable.

The US$3m payable to Tandrin was neither extravagant nor unconscionable in comparison with the greatest loss that Tandrin could have suffered (Tandrin’s actual loss was US$7.75m).

2. Would the breaching party pay less to perform the contract?

If the sum payable by the breaching party is greater than the sum which it would have paid on performance, the clause will be an unenforceable penalty.

Aero Toy Store's breach comprised its failure to accept delivery of the aircraft and pay the entire purchase price (US$31.75m) to Tandrin.

3. Damage caused by the breach must be serious.

The sum due on default is a penalty when it is payable on non-material breaches of contract. The US$3m Deposit could be treated

as liquidated damages by Tandrin in the event of Aero Toy Store failing to accept delivery of the aircraft and pay the balance of the purchase price (a material breach).

4. An exact prediction of damage is not required.

It would not prevent a liquidated damages clause from being an enforceable, genuine preestimate of loss if it was impossible to precisely estimate the damages that would result from breach.

Aggravating Factors

The Court found it straight forward to find in favour of Tandrin and, in doing so, highlighted the following relevant factors:

Liquidated damages clauses common in APA's. Not only are deposit/liquidated damages clauses industry standard but the APA's between Tandrin and JetCoast, between Tandrin and Aero Toy Store and between Tandrin and the eventual purchaser of the aircraft all contained a liquidated damages clause.

The amount of the Deposit was not unusual. The US$3m Deposit was neither unusual nor excessive. In the APA by which Tandrin purchased the Aircraft from JetCoast, the retention was 10% of the purchase price. In the APA by which Tandrin eventually re-sold the aircraft, the deposit was 7.3% of the purchase price. It is uncertain how the Court would have decided this point had the APA been signed in 2010 (when the market had cooled and deposits reduced significantly).

US$3m was a reasonable preestimate of Tandrin’s loss. In the “hot” market pre-2008, with prices foreseeably near their peak, a 10% pre-estimate of loss would have represented what could reasonably have been expected to be the drop in value of the aircraft if the market declined.

US$3m was less than Tandrin’s actual loss: Tandrin’s loss was US$7.75m, supporting the proposition that a US$3m preestimate of loss was anything but unjustifiably harsh to Aero Toy Store.

Deposit was proposed by Aero Toy Store. The offer of the US$3m Deposit was first suggested by Aero Toy Store and the draft APA (proposing that the Deposit be treated as non-refundable and that Tandrin be entitled to treat it as liquidated damages in the event of default by the purchaser) was first produced by Aero Toy Store. In considering whether the US$3m Deposit was extravagant or unconscionable, the Court thought it relevant that it was Aero Toy Store who proposed it commenting "It lies ill in Aero Toy Store's mouth now to contend that the US$3m is a penalty, given that both the amount of the Deposit and its characterisation as liquidated damages originated from Aero Toy Store".

Tandrin post-Cavendish

The Supreme Court in Cavendish stated that too much emphasis had historically been placed on the principles set out in the Dunlop case - which were intended to be guidelines, not hard and fast rules. The result in Tandrin would, however, still be the same if that case was heard today.

Both Tandrin and Aero Toy Store were well advised commercial parties who understood what they were agreeing to as regards the consequences of breach. On default by Aero Toy Store, Tandrin would be left with a depreciating aircraft and the costs of aircraft ownership. Under Cavendish, those wider commercial concerns could be taken into account.

The (secondary) obligation to pay liquidated damages only took effect to provide for a remedy in the event of breach by Aero Toy Store of its (primary) obligation to pay the balance of the purchase price on delivery. Tandrin would not, however, have had to justify the US$3m Deposit as a genuine pre-estimate of its likely loss.

Instead (post-Cavendish) it would be sufficient to show that the Deposit (to the extent that it sought to deter breach by Aero Toy Store) was neither grossly disproportionate nor unconscionable in comparison to Tandrin's interest in enforcing the APA. The relative ease of the test set out in Cavendish should give buyers and sellers of aircraft greater certainty that properly drafted liquidated damages clauses will be enforced by English courts.

Alan Cunningham | Partner DLA Piper [email protected]