25 February 2015

If you are omitting works or amending your contract, watch out!

Julie Teal
Partner | UK

You want to undertake works and you appoint a contractor. You then change your mind, and decide to omit some of the works or amend the contract. You will need to consider whether this has an impact on other contractual provisions. In a recent case, the court has ruled that a commercially agreed liquidated damages provision was a penalty. 

Unaoil, a company incorporated in the British Virgin Islands brought a case to the High Court against a company called Leighton Offshore incorporated in Singapore in Unaoil Ltd v Leighton Offshore Offshore PTE Ltd [2014] EWHC 2965. The former company has experience in the oil and gas sector principally in ‘challenging locations’ for matters such as camp solutions, technical workforce etc. for construction / engineering projects, and was appointed (a point which was also debated in the High Court) as a subcontractor of Leighton’s, a leading engineering and construction constructor. Both parties entered into a memorandum of agreement (MOA) for a project in Iraq. Unaoil amongst other claims, required Leighton to pay liquidated damages in the sum of US$40 million for the reasons explained below.

What are liquidated damages?**

Leighton agreed to pay Unaoil liquidated damages if Leighton was awarded the contract for the project in Iraq, but Leighton did not in turn adhere to the terms of the MOA. The court found prima facie that Leighton became liable to pay the US$40 million, but as you will see from the following this was held to be unenforceable.

Liquidated damages, as the example above shows, is a fixed sum that the parties to a contract agree, where one party (the defaulting party) will pay the other (the recipient party) in the event of a specific breach by the defaulting party. However, if the liquidated damages payment is not a genuine pre-estimate of the loss that is likely to be suffered by the recipient party, this can be held to be a penalty by the court, and the liquidated damages provision will be unenforceable.

As a further example, in a construction contract, liquidated damages come in to play where a contractor delays works such that practical completion is not reached by the completion date. In such an event, the contractor agrees to pay the client instructing the works liquidated damages for delay, usually a figure calculated on a weekly basis and pro-rated.

What must you watch out for?**

In the Unaoil case, there were no documents available to indicate how the US$40 million had been calculated. Therefore, whilst negotiating liquidated damages in a contract, it would be wise to consider the evidence, proof or commercial justification for arriving at the liquidated damages sum.

More importantly, in the Unaoil case, the initial price of the contract that Leighton was tendering for of US$75 million, was reduced to US$55 million but with no similar reduction to the liquidated damages sum of US$40 million. The court considered that once the original contract price was reduced, it was on any objective view, ‘extravagant and unconscionable with a predominant function of deterrence’ without any other commercial justification for the clause. For these reasons, the court found the liquidated damages clause to be a penalty and unenforceable.

Therefore, if you as the party to a construction contract wish to omit works or reduce the scope of the works, it would be wise to consider the effect on the liquidated damages provision, and whether the figure will need to be negotiated down with the contractor, at the same time. 

Category: Article