REUTERS | David Mdzinarishvili

Penalties: a genuine re-estimate of loss?

As a solicitor in private practice, I am routinely subjected to training on anti-money laundering rules. These courses place you in hypothetical scenarios and offer you multiple choice questions, such as should you (a) run screaming to the Police and national press; (b) ignore your suspicions and pocket the fees; or (c) have a quiet chat with the firm’s MLRO? The recent case of Unaoil Ltd v Leighton Offshore Pte Ltd not only presents a fascinating “real-life” version of one of these training scenarios, but also raises a new line of attack for parties challenging liquidated damages (LDs). 

The project

Leighton and Unaoil got together to bid for a US$700 million oil project in Iraq, with Unaoil to act as sub-contractor to Leighton. To this end, Unaoil and Leighton entered into a memorandum of agreement (MOA) for the Phase 1 works. The price under the MOA was US$75 million, made up of around US$35 million for engineering works and US$40 million for “support services”. The contract provided for a non-refundable advance payment of 15% of the fee and LDs of US$40 million if Leighton was awarded the main contract but breached the terms of the MOA. However, the MOA indicated that Unaoil would still provide the “support services” in these circumstances.

Subsequently, the MOA price was negotiated down to US$55 million.

Dispute and judgment

Ultimately the main contract was awarded to Leighton (triggering US$12.5 million in non-refundable advance payments), but Unaoil were never approved by the employer and Leighton awarded the sub-contract to others (triggering the US$40 million LDs). In accordance with the contract terms Unaoil then claimed US$52.5 million in damages for a US$55 million contract under which it appeared no work had ever been carried out.

Unsurprisingly, Leighton argued that the US$40 million LDs were penal. The judge, noting that the US$40 million equated to the US$40 million value attached to the “support services” that Unaoil was to provide irrespective of whether Unaoil got the sub-contract, stated (with some reservation) that he was content to assume that the US$40 million figure was a genuine pre-estimate of loss when the MOA was signed.

However, it is at this point that the judge departed from the usual track and went on say:

“I … fully accept what is trite law i.e. that the question whether the clause is a penalty or not must be viewed as at the date of the contract. However, where, as here, the contract is amended in a relevant respect, the relevant date is, in my judgment, the date of such amended contract… Here, once the original contract price was reduced… the figure of US$40 million was, even on Unaoil’s own evidence, manifestly one which could no longer be a genuine pre-estimate of likely loss by a very significant margin indeed…”

The judge then went on to assess Unaoil’s actual losses – an interesting exercise in itself, given that it involved assessing the cost of providing the rather nebulous “support services” that neither party was able to either satisfactorily describe, let alone cost.

A good principle?

The idea that a material amendment to a contract could result in the agreed LDs no longer being a genuine pre-estimate of loss sounds eminently sensible. If LDs are based on the loss of rent from 10,000 sq m and the contract is varied to halve the project to 5,000 sq m, then it would seem unfair not to revisit the LDs.

However, while this approach is superficially attractive, it opens up a whole new can of worms. If the reassessment of LDs is to be applied whenever the contract is “amended in a relevant respect”, then most current forms of building contract would become unworkable.

An employer usually has the power to unilaterally vary the scope of the works by issuing variations. However, unless an entire section is added or omitted, contracts do not usually allow for the LDs to be unilaterally varied at the same time. Following this case to its logical conclusion, if an employer were to issue a variation that amended the contract in a relevant respect, it would then find itself having to negotiate a change to the LDs with the contractor or risk the LDs falling away. The contractor would have an unconscionable amount of power in such negotiations.

Looking ahead

In practice, I hope that this case will be distinguished. It is well accepted that the parties are allowed a generous margin when pre-estimating their losses, and that they can allow for a range of contingencies (see Murray v Leisureplay plc). There is no reason, therefore, why the pre-estimate could not be deemed to allow for the likelihood that additions and omissions may be instructed.

This line of argument is readily reconciled with the present case. The decision in Unaoil was based upon the finding that the variation rendered the liquidated remedy:

“manifestly one which could no longer be a genuine pre-estimate of likely loss by a very significant margin indeed”.

As such, the need to reassess the LDs would depend on the materiality of the change. This would give the court a new tool in its armoury to strike down LDs where the result would otherwise be manifestly unfair, but would otherwise leave the application of the law largely unchanged.

I suspect that this decision may well result in a new line of cases as parties test the limits of its underlying principle. Hopefully the courts will see sense. However, if it is blindly followed it seems to me that the industry may need to move to a model where project managers must consider the impact of a variation on costs, time and LDs. In the meantime, all you adjudicators out there may need to brush up on your law of penalties and prepare yourselves for the anticipated surge in penalty claims.

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