Liquidated damages clause held to be unenforceable penalty
UNAOIL v LEIGHTON OFFSHORE [2014]
The Court held that a liquidated damages clause requiring a contractor to pay its sub-contractor US$40 million in the context of a sub-contract worth US$55 million was an unenforceable penalty.
Facts:
- The parties signed a memorandum of agreement (MOA) when Leighton (L) tendered for an oil pipeline project, because it failed to formally engage Unaoil (U), its sub-contractor, when its bid succeeded.
- The MOA said that if L was awarded the contract it would pay U liquidated damages (LDs) of US$40 million as a genuine pre-estimate of the loss that U would incur if L failed to honour the terms of the MOA. The MOA also stated that the sub-contract was worth US$75 million.
- The MOA was later amended so that, amongst other things, the proposed sub-contract price was reduced to US$55 million.
- L's tender succeeded but it did not enter into a sub-contract with U. Instead, it made it clear that U would not be involved on the project, suggesting that this was because U had been rejected by the client. L eventually engaged a third party to carry out a large portion of the intended sub-contract works.
- Amongst other things, U claimed for the LDs which it said were payable in accordance with the MOA.
Decision:
- U’s claim for LDs failed. In rejecting the claim, the Court found that the LDs may have been a genuine pre-estimate of loss at the time the MOA was originally signed, but they became a penalty once the MOA had been changed to reduce the sub-contract price.
- Generally, whether a clause is a penalty or not must be viewed at the date of the contract but the judge commented that as the contract had been amended in a relevant respect, the relevant date was the date of the amended contract.
- Consequently, looking at the date the MOA was changed, the Court held that the amount of US$40 million was, "manifestly one which could no longer be a genuine pre-estimate by a very significant margin indeed" given that the amendment reduced the total price.
- It went on to say that the reason why the figure of US$40 million was not reduced at the same time as the contract price was not explained and it was perhaps a mistake or an oversight. In any event, once the original contract price had been reduced, the LDs figure was, on any objective view, "extravagant and unconscionable with a predominant function of deterrence" without any other commercial justification for the clause.
- For these reasons, the Court concluded that the LDs provision was a penalty and unenforceable.
Points to note:
- This decision highlights the potential consequences where contract amendments undermine the appropriateness of a previously agreed LDs provision and the importance of considering the impact of such amendments on the rest of the agreement.
- There are circumstances where the Courts will intervene and a LDs clause may be deemed unenforceable as a penalty such as in this case, but even so, where the parties are both commercial entities it is comparatively rare for the Courts to do this.