Liquidated damages, penalties and the dangers of renegotiating the contract price

Summary: The boundary between liquidated damages and penalties is a topic of perennial interest and one on which it is essential to keep up to date with the courts' thinking. In Unaoil Ltd -v- Leighton Offshore PTE Ltd [2014] EWHC 2965 (Comm) the High Court has held that a sum of US$40m "was or at least may have been" a genuine pre-estimate of the parties' loss in the context of a contract with an overall price of US$75m. However, when the price was reduced to US$55m, this was no longer correct, and the US$40m became "extravagant and unconscionable" and therefore unenforceable as a penalty. This conclusion was supported by the lack of any apparent commercial justification for the sum other than deterrence of a breach.

Background: In 2010, the parties signed a binding Memorandum of Understanding (MOA) in connection with a substantial oil infrastructure project in Iraq. The contract, which was worth US$75m overall, provided that Unaoil would be entitled to liquidated damages of US$40m if Leighton Offshore failed to appoint Unaoil as its subcontractor. According to the clause in question, that figure had been chosen after careful consideration by the parties who agreed that it was "proportionate in all respects and a genuine pre-estimate of the loss which [Unaoil] would incur as a result of [Leighton Offshore's] failure to honour the terms of the MOA". In 2011, it became clear that, despite the parties' initial confidence, there was no guarantee that Unaoil would be chosen as subcontractor and the project would instead be put out to tender by the Iraqi state-owned oil company. As a result, the MOA was amended so that the price was reduced to US$55m, including a US$25m "marketing fee". The US$40m liquidated damages provision was not changed. Ultimately, Unaoil did not get the work despite being willing and able to perform, and claimed under the liquidated damages clause.

Contract price reduced; US$40m "no longer a genuine pre-estimate … by a very significant margin". Counsel for Unaoil, relying heavily on Makdessi -v- Cavendish Square [2013] EWCA Civ 1539, argued that the provision was enforceable for numerous reasons:

• the assessment of any liquidated damages sum has to be made at the time the contract was entered into (i.e. when the price was higher) and must take the context into account;
• the courts are generally reluctant to intervene, especially in a commercial context where the parties are of equal bargaining power and have had legal advice;
• the courts will adopt a "robust approach" to the assessment of any potential loss;
• the words used by the parties are persuasive, even if not determinative; and
• the correct approach to any such sum is not a simple dichotomy between "genuine pre-estimate" and "penalty" - the modern test is to ask, first, whether the sum is "extravagant and unconscionable with a primary function of deterrence" and, secondly, even if the answer is yes, to see if there is a commercial justification for the clause.

In connection with the final point, Unaoil argued that the clause had to be read in conjunction with another clause which obliged it to provide support services even if it was not appointed as subcontractor, and the US$40m was commercially justified in the basis that it was intended to pay Unaoil for those services as well as to compensate it for its potential loss of profits.

Eder J agreed with the principles but not on their application to the facts. Although he accepted that the US$40m was, or at least may have been, a genuine pre-estimate in the context of a US$75m price, the situation had to be reassessed when the MOA was amended, and that was the "relevant date" for the purposes of analysing the figures. However, once the price was reduced, the sum of US$40m was, even on Unaoil's own evidence, "manifestly one which could no longer be a pre-estimate of likely loss by very significant margin indeed … The reason why [it] was not reduced … was not explained. Perhaps it was a mistake or an oversight". The sum was a penalty, and Unaoil's claim failed.

Comment: Eder J did not give specific reasons for his decision other than relying on various pieces of financial information given in evidence. These included statements from Unaoil that the US$75m reflected market practice (in other words, that it represented the usual percentage of the total price of the project) and that, of that, the costs of Unaoil's works as subcontractor would have been around US$22-35m, which sum would have included a reasonable amount of profit. Unaoil also explained that the US$40m was chosen to cover payment for the support services which it would have provided anyway as well as to compensate it for its losses on breach. However, Eder J's obvious surprise at the lack of contemporaneous documents to support the figures, especially the US$40m and Unaoil's calculations of its costs as subcontractor, is a clear reminder of the wisdom of keeping notes of how liquidated damages (and connected) sums are arrived at.

Please click on the links below for the other articles in the February 2015 commercial contracts newsletter:

• Higher standard of care expected from specialist provider
• Construing payment obligations on breach of contract
• Court of Appeal confirms decision on repudiatory breach
• The importance of clear wording regarding "direct/indirect loss"
• Ensuring entire agreement clauses are fit for purpose
• Personal guarantor bound by signature machine