Penalty Rule - It's more than just a game LADs

23 October 2014

Not a topic of debate down the pub on a match day, but liquidated damages and penalty clauses are highly relevant during the negotiation of a contract.

Are they a genuine pre-estimate of loss or a means of putting pressure on the other contracting party, to compel performance? If the latter, then such a clause can be struck out as unenforceable unless it is commercially justified.

Liquidated damages or a penalty?

The key authority on the distinction between liquidated damages and penalties is Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited [1915]. It confirmed that liquidated damages are intended to be compensatory in nature and a "genuine pre-estimate" of the loss and damage likely to be caused by a breach of contract. By contrast, a penalty is an amount designed to threaten the offending party to prevent a breach - and operates in the nature of a 'fine'. A clause which is found to be a penalty is unenforceable.

The courts have been historically reluctant to uphold penalty clause arguments, being generally unwilling to interfere with the bargain agreed between the parties at the time of entering the contract. A new case has bucked that trend, with very significant consequences for the parties involved.

The Commercial Court decision in Unaoil Ltd v Leighton Offshore Pte Ltd [2014] highlights the potential consequences where subsequent contract amendments undermine the appropriateness of a previously agreed liquidated damages provision.

Background

Unaoil Ltd (Unaoil) commenced proceedings against Leighton Offshore Pte Ltd (Leighton Offshore) for breach of a Memorandum of Agreement (MOA) dated 10 December 2010 (as amended). Its complaint was that Leighton Offshore had failed to appoint Unaoil as its subcontractor for a substantial oil infrastructure project as part of efforts to rebuild Iraq's oil export infrastructure. This was, it said, a breach of contract.

Unaoil advanced three claims, one of which was a claim for liquidated damages in the sum of $40million. Article 8.1 of the MOA stated as follows:

"If Leighton Offshore is awarded the contract for the Project by the Client, and Leighton Offshore does not subsequently adhere to the terms of this MOA and is accordingly in breach hereof, Leighton Offshore shall pay to Unaoil liquidated damages in the total amount of USD 40,000,000 (Forty million US dollars). 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 Offshore's failure to honour the terms of the MOA".

Article 2.7 of the MOA provided for a fixed contract price of $75million. To win the project, however, the parties needed to reduce their respective lump sum prices. The MOA was therefore amended to reduce the all-inclusive lump sum price from $75million to a minimum price of $55million.

The Liquidated and ascertained damages (LADs) provision at Article 8.1 was not however amended and, on the face, continued to provide for LADs of $40million in the circumstances contemplated.

The court found that Leighton Offshore had failed to adhere to the terms of the MOA and that it was, prima facie, liable to pay $40 million by way of liquidated damages in accordance with Article 8.1. The question for the court was whether the liquidated damages provision was enforceable.

Leighton Offshore submitted that the provision was a penalty and unenforceable. Unaoil objected to this, and relied on the principles raised in the Court of Appeal decision Talal El Makdessi v Cavendish Square Holdings BV [2013] - in support of its submission that the sum was not a penalty. In particular, it submitted the following:

  1. the law of penalties is a blatant interference with freedom of contract;
  2. the burden of proving that a clause is a penalty is on the party making this assertion;
  3. whether a clause is a penalty is a question of construction to be assessed at the time of the contract;
  4. the court is generally reluctant to find that a clause is an unenforceable penalty, especially if the parties have had access to legal advice and are of equal bargaining power;
  5. the modern test requires the party making the assertion that a clause is a penalty to demonstrate: (1) that the clause in question is "extravagant and unconscionable with a predominant function of deterrence" and (2) even if that is demonstrated, that there was no other commercial justification for the clause.

Decision

The court considered that the figure of $40 million was, or at least may have been, a genuine pre-estimate of the loss when the unamended MOA was entered into.

The key factor was timing. Whether a clause is a penalty is normally judged at the date of the contract in question. If it is not penal at that date, the clause cannot become a penalty due to later events. However, the court decided that the contract between Unaoil and Leighton Offshore had been amended in a "relevant respect" and so the question of whether the clause was a penalty in this case had to be judged at the date of the amendments to the contract. Somewhat surprisingly, there was no previous authority on this point.

The reason why the LADs figure of $40 million was not reduced at the same time as the contract price was not explained but, once the contract price was reduced, the LADs figure became "extravagant and unconscionable with a predominant function of deterrence". There was no other commercial justification for the provision.

Unaoil's claim for liquidated damages therefore failed as the provision was deemed to be a penalty, and unenforceable for this reason.

Other decisions - are we now clear on the law of penalties?

The Unaoil case shows that there will be scope for challenge, if the right factual circumstances exist. In particular, subsequent amendments to the contract - including but not only to the contract price - could call into question a previously agreed level of liquidated damages.

The Court of Appeal judgment in Talal El Makdessi v Cavendish Square Holdings BV and another indicated that the courts remain reluctant to strike down a liquidated damages provision as a penalty, despite doing so in that case.

That case involved an agreement to purchase a number of shares in a company by way of instalments, at a price which included a premium for goodwill. The agreement contained restrictive covenants, breach of which would mean the seller would not be entitled to the outstanding instalment payments and would be required to sell the remaining shares in the company at an undervalue.

The agreement had been extensively negotiated and the parties had been legally advised.

The seller subsequently breached the restrictive covenants. The purchaser claimed that the arrangement was commercially justified to protect it for the loss of the goodwill arising as a consequence of the seller's breach. The seller successfully claimed on appeal that its inability to recover payment of the outstanding instalments and its obligation to sell the remaining shares to the purchaser at an undervalue constituted a penalty.

The Court of Appeal held not only that these provisions were not a genuine pre-estimate of loss, but also that there was no justifiable commercial basis for them - as the amount payable by the seller for such a breach was out of all proportion to the loss that would be suffered.

The case of Bluewater Energy Services BV v Mercon Steel Structures BV [2014] also considered the enforceability of a liquidated damages clause, this time linked to unauthorised changes in personnel under a construction contract.

Bluewater claimed a sum from Mercon as compensation for a series of unauthorised staff replacements. The agreement in that case provided that Mercon could not change key personnel without Bluewater's prior approval and that it would pay liquidated damages for each staff replacement. The liquidated damages agreed at the outset ranged from €20,000 to €50,000. Mercon sought to argue that the agreed figures in fact operated as a penalty - i.e. a deterrent against staff replacement - and were not otherwise commercially justifiable.

The judge disagreed. He was of the view that the authorisation regime provided an important safeguard for Bluewater, and he accepted that the replacement of a key member of the project team could cause a great deal of disruption to the project.

In the context of the project, the court held that €20,000 to €50,000 was not unconscionable or extravagant and found that Mercon had not come close to demonstrating that the figures were penalties. They were enforced accordingly.

Commentary

The Unaoil case is a relatively rare case where liquidated damages have been struck down.

With the expansion of liquidated damages clauses beyond the traditional delay and performance failures, it seems clear that more arguments will be raised as to the enforceability of such clauses.

The courts are now looking closely at the "commercial justification" test. As such, even where a provision is not found to be a "genuine pre-estimate" of the loss that will be suffered, it may still survive if the recipient can justify their position commercially (Talal El Makdessi).

But be in no doubt: the courts remain reluctant to interfere in commercial contracts, unless the factual circumstances require otherwise. The Unaoil case is however a useful reminder that the courts will intervene, in the right case. Here, it was the amendment to the contract that was fatal.

The lesson to be learnt is clear: have the appropriateness of liquidated damages at the front of your mind, both when forming your agreement but also whenever a variation to the agreement is contemplated. The failure to do so here had dramatic consequences.


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