Heads of Terms’ or ‘Memoranda of Agreement’ (“MoA”) are commonly agreed by parties as a precursor to entering into more substantial agreements.
MoA are often intended by the parties to be broad statement of commercial intent to enter into a contract, rather than having contractual force themselves. Accordingly, MoA are often drafted with a more relaxed attitude towards their contents
However, no matter what the parties may have intended, a MoA can easily amount to a contract depending on its drafting, exposing the parties to unintended liabilities.
The recent case of Unaoil v Leighton Offshore amply demonstrates the risks presented by a loosely drafted MoA. The case is also the latest to consider whether a liquidated damages clause amounts to an unenforceable penalty.
The dispute arose out of large oil infrastructure project in Iraq. Leighton intended to pitch to be the main contractor for the project and Unaoil approached Leighton with a view to being engaged as a sub-contractor and suggested that parties pitch together for the project.
The parties entered into a MoA that set out payments terms, including:
- a non-refundable advance payment to Unaoil; and
- a liquidated damages clause for $40 million.
The relationship between the parties subsequently broke down. Leighton went on to be appointed as a contractor to the project but did not engage Unaoil as a sub-contractor.
Unaoil sued Leighton for breach of the MoA claiming:
- $12.5 million for the non-refundable advance payment as a debt;
- $40 million in liquidated damages; and
- $30 million in lost profits resulting from Leighton’s repudiation of the MoA.
Was the MoA enforceable?
Up until trial Leighton maintained that the MoA was too vague to have any contractual effect and that Unaoil had no cause of action.
However, Leighton conceded that position during trial and it is easy to see why. The MoA contained clauses that were clearly intended (and did have) contractual effect, such as a confidentiality clause and choice of law. Clauses such as these are often seen as the hallmarks of a contract having been formal and, indeed, can survive the termination of a contract.
As a result, Unaoil was entitled to sue under the MoA. The Court observed that the MoA was “very badly drafted” and that the disputes between the parties were probably due to the poor drafting.
Due to the bad drafting the Court had to rely heavily on the evidence of the witnesses and, in a very fact dependant judgment, the Court awarded Unaqoil its debt of $12.5 million and a further $5.8 million for lost profits (but for which Unaoil had to give credit of a debt claim, effectively wiping out the loss).
Tips for drafting a MoA
- Do not automatically assume a MoA has no contractual force simply because it is labelled “non- binding”.
- If the MoA is meant to be non-binding, take great care to ensure that none of the clauses can be interpreted as being contractual in nature, such as jurisdiction or dispute resolution clauses.
- Where possible, include such provisions in standalone side agreements, such as a non- disclosure agreement.
Liquidated damages or a penalty?
The final issue was whether Unaoil could recover the $40 million liquidated damages provided for in the MoA.
The law on penalty clauses has recently been debated in the Court of Appeal in the case of Makdessi v Cavendish (our briefing www.burges-salmon.com/Practices/disputes_and_ litigation/News/12083.aspx).
Relying on the principles stated in that case the Court was required to assess whether the amount of the liquidated damages clause was so out of proportion with the claimants expected losses so as to be “extravagant and unconscionable with the predominant function of deterrence”.
On the evidence before the Court, when the MoA was first entered into, Unaoil proposed contract price of $75 million was based on an expected profit margin of $50 million.
At that point the liquidated damages of $40 million were not extravagant or unconscionable. However, the MoA was subsequently varied and the price reduced to $55 million, which appeared to represent a profit in the region of $30 million. However, the liquidated damages clause was not varied at the same time and stayed at $40 million.
The Court held that the relevant time for assessing whether the liquidated damages clause was a penalty was date of the variation. At that point, the $40 million liquidated damages were well in excess of Unaoil’s expected profits of £30 million and were therefore a penalty that the court would not enforce.
It is therefore important that whenever parties agree to vary a contract price, that they also revisit any liquidated damages provisions at the same time to keep them in proportion to the contract price.
Calculating liquidated damages
- Calculate the amount of liquidated damages on the basis of a genuine estimate of expected loss.
- Make sure that the rationale for that estimation is robust and can be evidenced if the clause is later challenged.
- If the contract price is varied, re-check your expected loss calculations and vary the liquidated damages provision at the same time.
Although Leighton managed to escape the $40 million penalty clause, the MoA (and its bad drafting) still cost it $12.5 million plus (one would expect) a hefty legal bill.
This should serve as an important reminder to contracting parties not to enter into MoAs (or similar heads of terms) lightly and to pay careful attention to how they are drafted.