The case of Unaoil Limited v Leighton Offshore Pte Ltd  serves as an important warning when amending the pricing in contracts which contain liquidated damages clauses.
The parties were involved in the oil and gas industry in the Middle East. They entered an agreement for Unaoil to be appointed as Leighton’s subcontractor in respect of the onshore works for an oil pipeline in Iraq. The original contract price was $75 million but at that point Leighton had not yet been awarded the main contract. The parties agreed that if Leighton was awarded the contract and it then did not subsequently adhere to the terms of the agreement then Leighton was to pay Unaoil liquidated damages of $40 million. The clause stated:
“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 [agreement].”
The contract price was subsequently reduced to $55 million. Leighton was awarded the main contract but did not appoint Unaoil as its subcontractor. Unaoil claimed that Leighton was in repudiatory breach of the agreement and it issued proceedings which included a claim for liquidated damages of $40 million.
Leighton challenged the liquidated damages claim on the basis that it was a penalty and therefore unenforceable. Unaoil relied on the decision of the Court of Appeal in the case of Talal El Makdessi v Cavendish Square Holdings BV  (involving a share sale agreement) in support of its arguments that the payment was not a penalty. The case includes a helpful summary of the principles from the El Makdessi case which were relied on and which included the following:
- The burden of proving a clause is penal is on the party making the assertion.
- Whether a clause is penal is a question of construction to be assessed at the time of the contract and requires the whole of the contract to be examined in the circumstances and context in which it was made.
- The court is generally reluctant to find a clause is penal and will not be astute to find a clause in a commercial contract is unenforceable, particularly if the parties are of equal bargaining power and have had a high level of legal advice.
- The court will adopt a robust approach to the assessment of the potential loss.
- 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 and treating as a penalty anything which is not a genuine pre-estimate of damage.
- The modern test requires the party asserting the clause is penal to demonstrate (1) that the clause 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.
The judge noted that the question of whether a clause is a penalty or not must be viewed as as at the date of the contract. However, here the contract had been amended in a relevant respect which meant that the relevant date was the date of the amended contract. Once the contract price had been reduced to $55 million the judge found that even on Unaoil’s evidence the amount of liquidated damages sought was one which could manifestly no longer be regarded as a genuine pre-estimate of Unaoil’s likely losses, by a very significant margin. Once the contract price was reduced the liquidated damages clause became “extravagant and unconscionable with a predominant function of deterrence” without any other commercial justification for the clause.
The judge therefore found that the liquidated damages clause was a penalty and was unenforceable.
Whilst the basis of the liquidated damages clause in the Unaoil case was somewhat unusual, the decision may have implications in construction contracts where liquidated damages clauses are often included for delay and where the contract price may be substantially reduced as a result of variations and omissions.
The court’s finding that a liquidated damages clause is a penalty does not prevent the claimant from bringing a claim for unliquidated damages (subject to any other contractual provisions limiting or excluding loss) but it would need to prove the damages suffered and this can be a tricky and expensive business. It is precisely for this reason that liquidated damages clauses can often be an attractive proposition to parties negotiating a contract.
The lesson to be learnt from the case is that if significant amendments are being made to a contract then the parties should consider whether the liquidated damages clause remains a genuine pre-estimate of likely loss. If not, they should consider whether the liquidated damages provision should also be amended to reflect the other changes to the contract.
For more information about the issues raised in this article or to find out more about how the Construction disputes team can help you please contact Rowan Turrall on 0118 952 7206 or email [email protected].
Consistent with our policy when giving comment and advice on a non-specific basis, we cannot assume legal responsibility for the accuracy of any particular statement. In the case of specific problems we recommend that professional advice be sought.