Liquidated damages clause unenforceable?
The recent case of Unaoil Ltd v Leighton Offshore PTE Ltd highlights the risk that liquidated damages clauses may become unenforceable after a contract variation.
- The intricate difference between a liquidated damages clause, and an unenforceable penalty.
- How to avoid a clause that you thought was enforceable, becoming unenforceable.
- The value that we add to drafting a commercial contract, fit for purpose.
As a remedy for failing to deliver on time, not meeting agreed service levels, or otherwise acting in breach of contract, commercial contracts will often include a provision requiring the guilty party to make payment of a fixed sum in damages– a simple and certain remedy.
The problem with liquidated damages clauses – drafting is key
However, the main problem with such a “liquidated damages” provision is, if it is deemed to constitute a threat to ensure performance of the contract rather than being aimed at compensating the injured party (with the amount payable being “extravagant or unconscionable” going well beyond any loss that would be suffered) it will constitute an unenforceable penalty clause. If so, then the party in breach can avoid payment.
The test that the courts will apply
For these purposes an important test applied by the courts is whether the sum agreed as payable is a “genuine pre-estimate of loss”. In arriving at a figure, a fairly broad brush commercial estimate of possible losses will be sufficient. The courts aren’t looking unnecessarily to interfere with the parties’ right to agree terms. Legal advice will help quantify the expected loss, and whether that loss is reasonable to be considered a “genuine pre-estimate of loss”.
The sum under a penalty clause
However, what if the sum agreed as liquidated damages, even if based upon a “genuine pre–estimate of loss” at the time the contract was entered into, proves to be entirely wrong? The basic principle is that the clause will still be valid and the agreed sum payable. The time to assess whether the clause is a penalty is at the time the contract is entered into, not at a later date. However, as has now been made clear by the case of Unaoil Ltd v Leighton Offshore PTE Ltd, this principle is subject to an important condition.
The facts of Unaoil Ltd v Leighton Offshore Offshore PTE Ltd
In this case there was a liquidated damages clause providing for a payment of $40m for breach of a contractual Memorandum of Agreement (MOA). The figure was, in part, calculated by reference to a contract value of $70m. However, the MOA was amended, such that the contract value was reduced to $55m. The MOA was then breached, with the injured party seeking to claim the $40m in liquidated damages.
The Court’s position
The judge ruled that whilst the validity of liquidated damages clauses should be assessed at the time they are entered into (and the clause in question was valid at that time) the position should be reassessed at the time a contract is varied where, as in this instance, the contractual variation is relevant to the liquidated damages clause. Accordingly, the liquidated damages clause, taking into account the significant reduction in contract value, was now deemed to be an invalid penalty clause, as it went “above and beyond” a “genuine pre-estimate of loss”.
Evidently where contracts are being amended, particularly where the amendments are relevant to the value of the contract, liquidated damages clauses should be reviewed and amended.
In addition, the case is a reminder to make sure liquidated damages clauses are properly drafted in the first instance. For example, it may be possible to take account of future changes to contract value by expressing the amount payable in liquidated damages as a percentage of contract value, not as a fixed sum.
It may also be appropriate for a party to be allowed to sue for damages, as an option to enforcing a liquidated damages clause, or it may make sense to avoid a liquidated damages clause altogether, with payments being made by reference to the level of service provided, rather than for a breach of contract, so avoiding there being any risk of there being an unenforceable penalty clause.