Legal Briefing

Penalty clauses: no one is immune

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Corporate and commercial | 01 November 2014

All too often parties amending a term of a contract will give insufficient consideration to how the amended term will interact with the remainder of the contract. Where the contract contains a liquidated damages clause, parties must be alive to the fact that the amendments may lead to a change in the value of the contract and should, therefore, trigger a review of the specified damages to ensure they have not become penal.


LIQUIDATED DAMAGES CLAUSES

When properly drafted, liquidated damages clauses are a useful tool by which to provide certainty in the event of a breach and avoid lengthy litigation regarding quantum. However, any such benefit will be lost if the specified damages are deemed to be penal.

In the decades following Dunlop v Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915], the question as to whether or not a liquidated damages clause was penal or not was answered by establishing whether or not the specified damages were a genuine pre-estimate of loss. More recently, however, the courts have taken a decidedly more commercial approach, explicitly recognising that there is not necessarily a strict dichotomy between a genuine pre-estimate of loss and a penalty clause. The Court of Appeal in Cavendish Square Holdings v Makdessi [2013] set out a two-stage process for the interpretation of liquidated damages clauses:

  • Is the clause extravagant and unreasonable?
  • If so, is there any commercial justification for the clause?

Accordingly, even if the damages specified are disproportionate to the amount likely to be suffered, the court must consider whether there is any other commercial justification for the clause so that it may not be said that the primary purpose of the clause is to act as a deterrent.

Lord Justice Christopher Clarke, giving the lead judgment, set out four matters to be taken into account by the court in deciding whether a liquidated damages clause is penal:

  • It is for the party who claims that it is a penalty clause to establish that it is penal.
  • The contract must be examined as a whole in the circumstances and context in which it was made.
  • It will not be astute of the court to find that a clause contained in a commercial contract is unenforceable because it is penal, especially if the parties are of equal bargaining power and have had high-level legal advice. The court recognises the utility of liquidated damages clauses and that to hold them to be penal is an interference with freedom of contract.
  • To that end it will adopt a robust approach. If the likely loss is within a range, an average figure or a figure somewhere within the range is likely to be acceptable. If the loss is difficult to assess a figure which is not outrageous may well be acceptable.

FACTS OF UNAOIL

The defendant, Leighton Offshore PTE Ltd (Leighton), an oil and gas contractor, had agreed to subcontract the claimant, Unaoil Ltd (Unaoil), in the event that it was successful in securing a contract to an oil export development project in Iraq with the state-owned South Oil Company (SOC) via a tender process. The agreement was set out in a memorandum of agreement (the MOA) between the parties. Under the terms of the MOA, Unaoil was to provide onshore services at a cost of $75m.

The MOA contained the following liquidated damages clause:

‘If [Leighton] is awarded the contract for the (main) project by [SOC], and [Leighton] does not subsequently adhere to the terms of this MOA and is accordingly in breach hereof, [Leighton] shall pay to [Unaoil] liquidated damages in the total amount of USD 40,000,000. 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 [Leighton’s] failure to honour the terms of the MOA.’

The MOA further specified that, in the event Leighton did not adhere to the terms of the MOA, Unaoil would nevertheless continue to assist Leighton with the completion of the project with certain additional services (the additional services).

The MOA was subsequently amended to lower costs in order to enhance the prospects of a successful bid (the amended MOA). Under the amended MOA the cost of Unaoil’s services was reduced to $55m. No change was made to the liquidated damages clause.

Leighton secured the contract but SOC would not approve Unaoil as a subcontractor. In light of this, Leighton informed Unaoil that:

‘… due to [SOC’s] position in respect of their rejection of you as a sub-contractor our agreement is null and void’.

Unaoil issued proceedings against Leighton for repudiation of the MOA, claiming (among other things) liquidated damages of $40m.

SUBMISSIONS IN RESPECT OF LIQUIDATED DAMAGES

Leighton contended that the liquidated damages clause was a penalty clause and therefore unenforceable. Unaoil contested this on a number of grounds and relied, in particular, on Cavendish and the four matters specified by Clarke LJ, set out above.

Referencing the requirement that the contract must be examined as a whole in the circumstances and context in which it was made, Unaoil argued that, in the circumstances the MOA (as opposed to the amended MOA) was made, the specified damages were not penal. Further, the clause had to be read in conjunction with the requirement that Unaoil continue to provide services even if Leighton did not appoint it as subcontractor. Finally, the MOA was between two commercial parties, with equal bargaining power, who it could be presumed had access to high-level legal advice.

Unaoil’s chairman gave evidence (accepted by Mr Justice Eder) that Unaoil’s costs were based on a percentage of the overall costs of the project, in this case 7-12%, as this is what, in his experience, the cost of onshore services generally represented in a project of this type. His evidence was that it would be ‘useless’ to carry out a cost evaluation exercise as ‘in Iraq estimates are not estimates’ as ‘things change’.

JUDGMENT

In his assessment of the liquidated damages clause, Eder J accepted that the specified $40m may have been a genuine pre-estimate of costs under the MOA. He did, however, note that he was by no means certain of that fact, given the fact that the costing of the project by Unaoil was effectively a ‘punt’ and the lack of any contemporaneous documents to indicate how the contract price (and by extension the likely damages) was reached.

Addressing Unaoil’s submission that the liquidated damages clause was to be interpreted in the light of the circumstances and context in which the MOA was made, Eder J affirmed that the specified damages are to be assessed at the time the contract is executed. However, he went on to clarify that when a contract has been amended in such a way as to change the contract value, the liquidated damages clause is to be assessed at the time of the amendment. Accordingly the specified damages of $40m was to be assessed against the amended MOA contract price of $55m.

In light of the wholesale failure on Unaoil’s part to provide any compelling evidence as to the expected profit of the additional services, Unaoil’s argument in this respect was rejected.

Eder J concluded that, even if the $40m under the MOA had been a genuine 
pre-estimate of costs, it was clear that it could not be appropriate in the context of the amended MOA.

CONCLUSION

Contracting parties should not be lulled into a false sense of security by the recent, more commercial approach the courts have taken to liquidated damages clauses. As Clarke LJ was at pains to point out in Cavendish, while the court will be reluctant to interfere with parties’ freedom of contract, ‘the fact that a liquidated damages clause has been agreed between parties of equal bargaining power who have competent advice cannot be determinative’ or result in such clauses ‘enjoying immunity from the doctrine’.

Eder J’s ‘surprise’ at the lack of documentary evidence supporting 
Unaoil’s costs and, by extension, its 
likely damages should be heeded. While it is now well established that difficulties in determining future damages will not be fatal to a liquidated damages clause, parties would be well advised to at least attempt such an exercise so as to be in a position to provide documentary evidence that supports the damages specified or at least indicates that they are ‘not outrageous’.

The facts of this case were such that it was a straightforward and obvious conclusion that the reduction of the contract price meant that the liquidated damages clause became penal. However, it is likely that any significant adjustment to obligations and/or price will result in a presumption that an unamended liquidated damages clause will be challenged for being extravagant and unreasonable. To avoid unnecessary litigation, contracting parties should assume that any amendments to a contract containing a liquidated damages clause must entail a review of likely loss.