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liquidated damages... time to re-assess?

14 October 2014

In Unaoil Ltd v Leighton Offshore PTE Ltd [2014] EWHC 2965 (Comm) the Commercial Court held that where a contract containing a liquidated damages clause is subsequently amended in a "relevant respect", the question of whether or not that clause is a penalty should be determined by reference to the date of amendment, rather than when the contract was originally agreed. This decision is important, since it represents an extension to the existing law.

Background 

Liquidated damages clauses are widely used in construction and engineering contracts to reflect a pre-determined estimate of the loss that a party may reasonably incur if a specified breach of contract occurs. Most often this is a failure to complete the works on time, although they can also be used for other breaches of contract (as in Unaoil). The main advantages of agreeing a rate of liquidated damages are that it provides certainty and avoids the need to quantify actual levels of loss (which can be an expensive and time consuming exercise).

It is important that liquidated damages reflect a genuine pre-estimate of loss. If they do not, they may be deemed to be a penalty and the clause unenforceable. English courts have previously held that whether or not a clause amounts to a penalty will be determined by reference to the particular circumstances at the date of the contract and not at the date of the breach.

The facts

Leighton Offshore PTE Ltd (Leighton) approached Unaoil Ltd (Unaoil) regarding a proposed sub-contract for a substantial infrastructure project relating to a crude oil export facility reconstruction project in Iraq. The parties agreed to submit a joint tender for the project and entered into a Memorandum of Agreement (Agreement) to reflect the general terms of sub-contract if the tender was successful. The price under the Agreement was US75 million, comprising some US35 million for engineering and US40 million for "support services".

The Agreement included a liquidated damages clause, which would take effect if Leighton was awarded the contract for the project but failed to sub-contract certain works to Unaoil. The clause provided for a payment of US40 million, stating: "After careful consideration by the Parties, the Parties agree such amount is proportionate in all respects and is a genuine pre-estimate of the loss that Unaoil would incur as a result of Leightons failure to honour the terms of this Agreement."

Shortly thereafter, the parties agreed to decrease the price to US55 million in an attempt to increase the chances of securing the contract for the project. However, the level of the liquidated damages clause remained unamended at US40 million.

Leighton was subsequently awarded the contract for the project but declined to enter into the sub-contract, stating that the employer allegedly had not approved Unaoil as a sub-contractor. Unaoil issued proceedings to (amongst other things) seek an order for payment of the sum set out in the liquidated damages clause.

The decision

The court concluded (with caveats) that the level of the liquidated damages clause was, or at least was intended to be, a genuine pre-estimate of loss at the date that the Agreement was originally formed (reflecting the "support services" Unaoil were to provide). However, it went on to find that where a contract is amended in a "relevant respect" (being in this case the change in price) then the relevant date for assessing whether or not the liquidated damages are a genuine pre-estimate of loss is the date of amendment, not the date the contract was originally agreed.

In the context of this case, the court found that the figure of US40 million was - even on Unaoils case - no longer a genuine pre-estimate of loss, but objectively "extravagant and unconscionable with a predominant function of deterrence without any other commercial justification for the clause". Accordingly, the clause amounted to a penalty and was unenforceable.

Comment

This case is unusual, both in terms of the nature of the commercial deal and the bespoke (poorly drafted) form of Agreement. Accordingly, some care should be taken when considering how this might apply in a more generic construction context. However, with this in mind, a few key points to take away are as follows:

1. The courts decision regarding the relevant date for assessing if the liquidated damages clause is a genuine pre-estimate of loss is an extension of the law.

2. Accordingly, it is important for parties and project managers to consider whether or not any contract amendments may impact on the reasonableness of the level of liquidated damages.

3. As with any change to the law, it seems likely that the extent of this principle will be tested in subsequent cases. In the meantime, some guidance is available with regard to what will trigger the need to review your liquidated damages. Here, the court was clear that US40 million was "manifestly … no longer … a genuine pre-estimate of likely loss by a very significant margin indeed". So it is clear that a change must not only be relevant but also material. Further, previous cases make clear that a clause will not become a penalty simply because it results in overpayment in particular circumstances - the parties have a "generous margin". Nevertheless, the decision opens up a new line of attack for contractors, who might either wish to strike down liquidated damages clauses or seek to re-open commercial negotiations regarding the level of liquidated damages.

4. Finally, it seems likely the principle will extend beyond changes to the contract price to other "relevant" contract amendments. An obvious example is liquidated damages for delay. Imagine a contract for the construction of a sports stadium where the level of liquidated damages is based on a pre-estimate of loss in respect of delay and the costs that would flow from a failure to host particular events. Here, an amendment to the date for completion of works which moved completion so that the stadium could no longer host one of those events would make the original calculations no longer applicable. So, assuming that a contract does not already address this scenario, parties should now also reconsider their calculations for liquidated damages in the event of a relevant contract amendment.

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The content on this page is provided for the purposes of general interest and information. It contains only brief summaries of aspects of the subject matter and does not provide comprehensive statements of the law. It does not constitute legal advice and does not provide a substitute for it.

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