Contract amendments may leave liquidated damages clauses vulnerable

A Commercial Court decision last week could have significant ramifications for liquidated damages (“LDs”) provisions in construction contracts. Although upholding Unaoil's debt claim and loss of profit claim, the court struck down a liquidated damages clause on the basis that subsequent contract amendments had undermined the genuineness of the LDs originally specified in the clause. The decision is the first to consider the impact of contract amendments on LDs clauses and is also notable for upholding a penalty argument in the face of an express provision deeming the clause to be a genuine pre-estimate of loss.

The Background

Unaoil Ltd (“Unaoil”) and Leighton Offshore PTE Ltd (“Leighton”) agreed to jointly tender to the South Oil Company (“SOC”) in respect of the Iraq Crude Oil Expansion Project. Unaoil and Leighton entered into a Memorandum of Agreement in respect of project (“MOA”) whereby Leighton agreed to appoint Unaoil as its sub-contractor for onshore construction works in the event that Leighton was appointed as main contractor by SOC. Leighton agreed to pay liquidated damages in the event that it failed to comply with its obligations under the MOA.

Leighton was subsequently appointed by SOC as main contractor but refused to appoint Unaoil as its sub-contractor, claiming that Unaoil was no longer approved by SOC. Unaoil disputed this and raised proceedings to recover liquidated damages (among other things).

The LDs clause

Unaoil’s claim for LDs relied on Article 8 of the MOA which stated that if Leighton was awarded the contract by SOC and did not then adhere to the terms of the MOA, it would pay LDs to Unaoil in the amount of $40 million. Article 8 also provided that: “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.”

The original contract price under the MOA was $75 million, however the parties later amended the MOA to reduce the contract price to $55 million. No amendment was made to the LDs clause to reflect this reduction and the LDs remained at $40 million.

Clause found to be a penalty

Unaoil was successful in arguing that Leighton had failed to adhere to the terms of the MOA and was prima facie liable for liquidated damages under Article 8. In defence, Leighton submitted that Article 8 constituted a penalty and was therefore unenforceable. In order to succeed, Leighton needed to show that the clause was “extravagant and unconscionable with a predominant function of deterrence” rather than being a genuine pre-estimate of the loss likely to be suffered by Unaoil in the event of a breach of the MOA. This is generally recognised to be a difficult test to satisfy and the courts are generally reluctant strike down a clause which, as in this case, had been freely agreed between two large commercial organisations.

The court was prepared to assume that the LDs clause at the time of the original MOA was a genuine pre-estimate of loss and not therefore a penalty. However, the amendment to the MOA had reduced the contract price to $55 million and at that time, the court found that $40 million “could no longer be a genuine pre-estimate of likely loss by a very significant margin.” Although there was no previous case law on the topic, the court held that, “where … the contract is amended in a relevant respect, the relevant date [for determining whether the clause is a penalty] is … the date of such amended contract”. On this basis, the court struck down the LDs clause noting that once the contract price had been reduced, the clause was:
“on any objective view, extravagant and unconscionable with a predominant function of deterrence without any other commercial justification for the clause.”

Conclusion and broader implications

The court’s decision provides a reminder as to the care which is needed to ensure that liquidated damages provisions are “kept in step” with contract amendments. Although the drastic reduction in contract price considered by the court provides a helpfully clear example of when an LDs provision may be undermined by contract amendments, the implications of the decision may extend more broadly:

• Many construction contracts contain powers to omit works, yet few allow for liquidated damages to be adjusted based on the value of any omissions made. It is unclear whether or how the Unaoil decision might apply in circumstances where a large reduction in the contract price is effected through such an omissions clause rather than by way of a contract amendment. The decision may well apply to other contract amendments which leave the contract price unaffected but alter other commercially relevant aspects of the agreement. For example, a Deed of Variation which adjusts an agreed date for completion may make original calculations as to liquidated damages for delay no longer applicable (i.e. delay will now occur over a different period of time).
• The decision leaves open to question the extent to which changes in the parties’ understanding of likely losses are also to be taken into account. What is to happen, for example, if a contract amendment is agreed at a time when one or both of the parties has learned that the original pre-estimate of loss was over-inflated? The commercial aspects of the parties’ agreement may be left unchanged by the contract amendment, but must the parties still revise the liquidated damages clause to refresh the genuineness of the original estimate? The court seemed to place little emphasis on the fact that the parties had expressly agreed that the liquidated damages clause was proportionate and a genuine pre-estimate of loss. There is very little law on the extent to which such agreements are effective to displace the penalties doctrine and the Unaoil decision may suggest that parties should not place significant reliance on such clauses.

Reference: Unaoil Ltd v Leighton Offshore Offshore Pte Ltd [2014] EWHC 2965 (Comm)