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November 6, 2014

A Cautionary Tale: English Courts Further Depart from a Traditional Approach to Liquidated Damages in Unaoil v Leighton

In September 2014, the Commercial Court handed down an unprecedented decision, finding that a liquidated damages (LD) clause in a contract was a genuine pre-estimate of loss at the time the parties entered into the contract, but later became a penalty upon amendment to reduce the contract price. The decision of Mr. Justice Eder in Unaoil Ltd v Leighton Offshore Pte Ltd[2014] EWHC 2965 (Comm) ( Unaoil v Leighton) breaks new ground, departs from previously well-established rules of interpretation, and may have a number of practical implications on contract amendments governed by English law.

What Happened?

In 2010, the claimant, Unaoil (a provider of services to the oil and gas sector in the Middle East, Central Asia and Africa) approached the defendant, Leighton (a leading international contractor, particularly active in the mining and resources sector), with a view to the two companies working together to obtain work on a crude oil expansion project in Iraq. Upon agreeing to work together, the parties entered into various documents concerning different phases of the expansion project pursuant to which Unaoil would act as a subcontractor to Leighton. These documents included a Memorandum of Agreement signed in December 2010 (the MOA) in relation to the construction of an oil pipeline in the south of Iraq (the Project) for the Iraqi state-owned South Oil Company (SOC).

Pursuant to the MOA Leighton agreed that, should it succeed in winning the Project, it would appoint Unaoil as its subcontractor for the onshore construction works for the Project. The MOA contained an all-inclusive contract price of US $75 million, with LDs of US $40 million payable to Unaoil in the event that Leighton failed to adhere to the terms of the MOA. The LD provision of the MOA read as follows:

If LEIGHTON OFFSHORE is awarded the contract for the PROJECT by the Client, andLEIGHTON OFFSHORE does not subsequently adhere to the terms of this MOA and isaccordingly 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 OFFSHOREs failure to honour the terms of the MOA.

Subsequently, in April 2011, the parties entered into a supplementary agreement which amended the MOA so as to reduce the contract price of US $75 million to US $55 million (the Amendment). Significantly, the Amendment did not vary the LD amount of US $40 million.

In or around October 2011, SOC awarded Leighton the role of main contractor for the Project.

In January 2012, Unaoil sent invoices to Leighton claiming the first two advance payments due to it under the MOA. Leighton rejected these invoices, on the basis that SOC did not approve Unaoil as a subcontractor and the MOA was therefore null and void. Unaoil remained ready, willing and able to perform its obligations under the MOA, as amended, at all material times, and issued proceedings against Leighton in April 2012 for three main claims: (1) recovery of the advance payments as a debt; (2) damages for loss of profits; and (3) LDs of US $40 million.

The Decision

Eder J upheld Unaoils debt claim and found Leighton liable for damages, although his Honour assessed an amount of damages less than the debt and therefore such claim did not alter the total award. However, the most intriguing and perhaps controversial part of the judgment related to Unaoils claim for LDs, which his Honour ultimately rejected on the basis that the LD clause constitutes an unenforceable penalty.

Proceeding on the assumption that Leighton failed to adhere to the terms of the MOA, his Honour accepted that (a) Leighton became, or would in due course become, prima facieliable to pay US $40 million by way of LDs to Unaoil, 1 at the time of the original MOA (when the contract price was US $75 million), the figure of US $40 million was a genuine pre-estimate of the loss likely to be suffered by Unaoil in the event of Leightons repudiation, and (c) the question of whether a clause is a penalty or not must be viewed as at the date of the contract. [2]

And this is where it gets interesting. Where, as in this case, the contract is amended in a relevant respect, the relevant date of the contract is, in his Honours opinion, the date of the Amendment, rather than the date of the original MOA. In his Honours own words: [3]

So far as I am aware, there is no authority to such effect but it seems to me that this is consistent with the general principle. Here, once the original contract price was reduced by [the Amendment], the figure of US $40 million was, even on Unaoils own evidence, manifestly one which could no longer be a genuine pre-estimate of likely loss by a very significant margin indeedThe reason why the figure of US $40 million was not reduced at the same time as when the contract price was reduced was not explained. Perhaps it was an oversight. I do not know. In any event, once the original contract price was reduced, it was, on any objective view, extravagant and unconscionable with a predominant function of deterrence without any other commercial justification for the clause.

Unprecedented, Yet Perhaps the Way Forward?

Whilst the decision in Unaoil v Leightonis unprecedented, it appears logical and comes at a time when recent UK authorities have demonstrated that the question of whether a clause is penal should not be answered by assuming a complete dichotomy between what is and what is not a genuine pre-estimate of damage at the time of entering the contract, and treating as a penalty anything that does not fall within the former category. [4] Rather, the Courts have shown an increasing willingness to adopt a more flexible and wide-reaching approach to interpreting LD clauses, rather than adhering strictly to the traditional approach. The following cases demonstrate this evolution:*in 1996, in Lordsvale Finance plc v Zambia [1996] QB 752, the Court held that there seemed to be no reason why a contractual provision, the effect of which was to increase the consideration payable under an executory contract upon the happening of a default should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, provided its dominant purpose was not to deter the other party from breach; [5]

*in 2004, in Cine Bes Filmcilik ve Yapimcilik v United International Pictures [2004], the Court held, following Lordsvale, that a dichotomy between a genuine pre-estimate of damages and a penalty does not necessarily cover all the possibilities. There are clauses which may operate on breach, but which fall into neither category, and they may be commercially perfectly justifiable; [6]

*in 2005, in Murray v Leisureplay[2005] EWCA Civ 963, the Court held that the fact that a clause may result in a greater recovery than the actual loss did not automatically mean that without further justification the clause was penal. Such comparison is relevant but no more than a guide to the answer to the question whether the clause is penal. Rather, a penal clause needed to be extravagant and unconscionable. Further, a clause may still be commercially justifiable, provided that its dominant purpose is not to deter the other party from breach; [7]

*in 2010, in Azimut-Benetti SpA (Benetti Division) v Darrell Marcus Healey[2010] EWHC 2234 (Comm), the Court held that, although it may not represent a genuine pre-estimate of loss, the purpose of the clause in question was not deterrent and that it was commercially justifiable as providing a balance between the parties upon lawful termination. The terms were freely entered into and in a commercial contract of this kind, what the parties have agreed should normally be upheld; [8] and

*most recently, in 2013 in Talal El Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 153, the Court of Appeal looked to a number of tests and distinguished between what it referred to as the old approach (the traditional dichotomy, referred to above) and the new approach (as per Lordsvaleand Murray). Applying the new approach to characterising a clause as a penalty, the Court in Makdessi concluded that merely considering whether a clause represents a genuine pre-estimate of loss or is otherwise extravagant and unreasonable is not conclusive evidence of a penalty. Rather, the court must go on to consider whether there was a good commercial justification for the clause and if there is, a clause which is not a genuine pre-estimate of loss may not necessarily be penal. [9]

But what does it all mean?

Recent case law, culminating in Unaoil v Leighton,demonstrates the Courts willingness to adopt a more flexible approach when it comes to the enforceability of LD clauses and not shy away from breaking new ground. In Unaoil v Leighton, Eber J made particular note of the fact that in that case, the MOA was very badly drafted and that the disputes that were the subject of the proceedings were probably due, in large part, to such bad drafting. [10]

Practically speaking, this means that during contractual negotiation and amendment, parties cannot simply seek to rely on the inclusion of express wording in the contract that the agreed LDs constitute a genuine pre-estimate of loss. Parties instead need to have a heightened sense of awareness as to whether any amount specified in an LD clause is reasonable, commercially justifiable and/or actually a genuine pre-estimate of loss at that time. Importantly, contracting parties should consider whether they have amended the contract in any relevant respect that may impact on a previously agreed LD clause. If not, the relevant date for analysing the clause will remain the original contract date. If so, the relevant date may well become the date of such amendment. Obviously a large reduction in contract price provides just one example (albeit, a very good one) and what might otherwise constitute such a relevant amendment needs to be considered on a case-by-case basis. Other examples to bear in mind include:

*an amendment to the completion, or taking over date, under a construction contract;

*a change to the price of liquefied natural gas (LNG), or delivery schedule, in a sale and purchase agreement for LNG;

*a change in the price of electricity in a power purchase agreement (PPA), or the scheduled commercial operation date under such PPA; and

*a change in the scope of a construction contract, which will delay the work of other construction contractors and increase the likelihood of delay claims by such other construction contractors, which may have an impact upon LD calculations made in the original contract.  

[1] At para. 68.

[2] At para. 68.

[3] At para. 71.

[4] As contended by Counsel for Leighton at para. 69, referring to the judgment of Talal El Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 1539, at para. 54.

[5] At page 764.

[6] At para. 15.

[7] At para. 106.

[8] At para. 29.

[9] At para. 117, with reference to the earlier notable decision of Lordsvale, which arguably paved the way for consideration as to whether a clause was commercially justifiable and not just a genuine pre-estimate of loss.

[10] At para. 15.