Our quarterly commercial law update covers contract law issues relevant to anyone drafting agreements day-to-day. This edition looks at: interpreting a ‘toothless’ clause; drafting a condition precedent; and assessing a liquidated damages clause.
If you’d like to hear more about these issues, we’d be happy to talk to your team.
Court will not re-write a clause that is clear but ineffective
The court will interpret an apparently absurd clause in a commercially sensible way only if the clause (i) is truly ambiguous; and (ii) suggests the parties had a clear alternative intention. The court will not read words into a clause merely to re-make a bad bargain.
Mr Huggett was an employee of Prophet, which designed software products for the fresh produce industry. He left Prophet to join another company that also designed software. His employment contract with Prophet contained a one-year restrictive covenant preventing him from working for any company that provided the same products he worked on at Prophet. In fact those products were produced only by Prophet, so the covenant had no ‘teeth’ if read literally.
The trial judge concluded that something had 'gone wrong' with the drafting. He read in the words ‘or similar thereto’, preventing Huggett working on other software used in the fresh produce industry. His decision was overturned in the Court of Appeal, with Lord Justice Rimer stating:
- Absurdity is not enough; a clause must be ambiguous for a court to reinterpret it. The literal interpretation of the clause rendered it useless, but there was no doubt what the words meant. And any reinterpretation of the clause would require the court to choose from a range of meanings for the types of software at issue; there was no clear alternative. There was no room for the court to reinterpret the clause, and it should be read literally.
- The context of the clause is important. Courts do not ‘easily accept that people have made linguistic mistakes, particularly in formal documents’ (Lord Hoffmann in Chartbrook v Persimmon Homes). Here, the draftsman had deliberately drafted the restrictive covenant narrowly, to ensure it was valid. He had chosen his words with deliberate and specific care. The clause was a piece of carefully drafted legal prose and it was not for the court to ‘remake’ the parties’ bargain.
When drafting a restrictive covenant, the usual concern is to ensure it is not so wide as to render it void. But always think about what it is intended to do, and test its wording against potential scenarios that it is seeking to prevent.
Contract must make clear if a clause is intended to be a condition precedent
A notice requirement in a conduct of claims clause is a condition precedent to making a claim only if the clause is clear about the parties’ intention.
Heritage sold Tullow a stake in exploration licences for two oilfields. The SPA contained a tax indemnity by Heritage Oil to Tullow, which required Tullow to give written notice of claims within 20 business days. Tullow claimed under the indemnity. Heritage disputed the claim, saying that Tullow hadn’t complied with the 20-day notice period.
The Court of Appeal upheld the High Court’s finding that the notice period wasn’t a condition precedent to making a claim. Classifying a term as a condition precedent might clarify the parties’ obligations, but might also deprive a party of a right simply because of a trivial breach that caused little or no loss to the other party. To make a term a condition precedent to claiming a right, the parties must make their intentions clear.
The words ‘condition precedent’ themselves are commonly used for this, but other words can have the same effect. In this case, the Court of Appeal noted that other clauses in the SPA had created condition precedents: eg ‘[the indemnity] shall not apply unless notice…is given to the Indemnifying Party within [time period]’. The court found it significant that the tax indemnity hadn’t used this language, when it had been used elsewhere - so check for consistency across clauses.
Date of contract amendment relevant for deciding whether a liquidated damages clause is a penalty
A liquidated damages clause, which was a genuine pre-estimate of loss at signing, became an unenforceable penalty when the parties later amended the contract. Previous cases assessed LD clauses only by reference to the signing date.
Leighton and Unaoil signed a Memorandum of Agreement relating to an Iraqi oil pipeline project, with a contract price of $75 million and an LD clause of $40 million. The parties later amended the contract, reducing the contract price to $55 million, but didn’t amend the LD clause. When Leighton didn’t perform, Unaoil claimed for the full $40 million.
The High Court accepted that the LD clause was a genuine pre-estimate of loss at the contract date. But, once the contract price was reduced, $40 million was ‘extravagant and unconscionable with the predominant function of deterrence’; ie it was a penalty and therefore unenforceable.
The issue here was timing: whether a clause is a penalty is normally judged at the date of the contract. If it’s not a penalty, then it can’t usually become one due to later events. But here, the court said the price reduction meant the contract had been amended in a ‘relevant respect’, so, in line with general principles, the clause had to be judged at the amendment date. This is a departure from previous cases, which assessed LD clauses only at the date of the contract.
In practice, consider whether your LD clause is a genuine pre-estimate of loss not only when forming an agreement, but also if you amend it. This is particularly important for long-term agreements that you might amend as the contract proceeds.