When a contract price is lowered by agreement between the parties, this may have an unexpected effect on the enforceability of any liquidated damages provision in the contract.
In Unaoil Ltd v Leighton Offshore Pte Ltd (12 September 2014), the English Commercial Court would not allow a claim for liquidated damages on the basis that, whether by intention or mistake, the parties did not adjust the liquidated damages provision in the contract when they agreed to lower the contract price, with the result that the provision no longer constituted a genuine pre-estimate of loss.
When deciding whether a liquidated damages provision is a penalty, the Court should take a view as at the date of the contract. Recognising that there was no previous authority to this effect, the Court held that it should follow and is consistent with this general principle that where the contract is amended “in a relevant respect”, the relevant date should be the date of the amended contract.
The defendant (Leighton) entered into a Memorandum of Agreement (MOA) with the claimant (Unaoil) under which Unaoil would supply certain onshore services as sub-contractor for an oil pipeline project in Iraq in return for a contract price of US$75 million. Leighton was bidding to be the main contractor on the pipeline in a tender process with the Iraqi state-owned oil company South Oil Company (SOC or Client).
The MOA contained the following liquidated damages provision:
“If LEIGHTON OFFSHORE is awarded the contract for the PROJECT by the Client, and LEIGHTON OFFSHORE does not subsequently adhere to the terms of this MOA and is accordingly 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 OFFSHORE’s failure to honour the terms of the MOA.”
In an attempt to make Leighton’s bid more attractive to SOC, both Leighton and Unaoil recognised that they would need to reduce their prices and the parties entered into a supplementary agreement under which the contract price payable to Unaoil was reduced from US$75 million to US$55 million.
Leighton’s tender succeeded and the main contract with SOC was executed. However, Leighton did not enter into a formal sub-contract with Unaoil. Unaoil continued to prepare for the project and submitted an invoice for the advance payments. Leighton failed to pay and eventually engaged a third party to carry out a large portion of the intended sub-contract works. Unaoil commenced court proceedings in England under the MOA claiming the advance payments, damages for repudiatory breach of contract and liquidated damages in the sum of US$40 million.
Leighton denied any liability.
Under the terms of the MOA, Unaoil was entitled to receive non-refundable advance payments. The Court held this entitlement was not void or invalid simply because Unaoil was not approved as a sub-contractor. Leighton’s defence that the MOA was, in effect, terminated was not relevant because Leighton’s obligation to pay had already arisen. Unaoil succeeded in its claim for the advance payments.
In relation to the claim for repudiatory breach, the Court recognised that it was very difficult to calculate Unaoil’s loss (including loss of profit) in such circumstances, but noted that this should not deprive Unaoil of a remedy. The Court awarded damages to Unaoil which were then credited against its successful debt claim, so that its total overall recovery did not increase.
In relation to its liquidated damages claim, Unaoil did not succeed. The Court applied the “modern test,” as set out in the recent Court of Appeal decision of Talal El Makdessi v Cavendish Square Holdings (26 November 2013), namely that the party seeking to assert that a liquidated damages provision is penal must demonstrate that provision is “extravagant and unconscionable with a predominant function of deterrence” and that there is no other commercial justification for the clause.
The Court would have accepted that US$40 million was a genuine pre-estimate of Unaoil’s loss at the time of the original MOA, but because the parties had not adjusted down the liquidated damages provision when they entered into the supplementary agreement which reduced the contract price significantly, it could not find that US$40 million was a genuine pre-estimate of Unaoil’s loss at the time the MOA was amended, which was the relevant time.
When varying a contract, particularly in relation to the price to be paid, quantity of goods to be supplied or level of services to be provided, it is important to review any contractual liquidated damages provisions to ensure that, as at the date of the amendment, the amount payable to one party in the event of the other’s default still constitutes a genuine pre-estimate of that party’s loss.