The penalty for seeking a penalty

December 2014

Rating system:

Reading time (1-10 minutes): 2

Sophistication level (1 (idiot) – 10 (expert)): 6

Entertainment value (1 (turgid) – 10 (side-splitting)): 5

Background:

You have to be very careful if you want to say in a contract that the other party must pay a pre-determined sum if it doesn’t do what it agreed to. The law says that if this sum is a genuine estimate in advance of the loss you might suffer it will be called ‘liquidated damages’, whereas if it is designed to scare the other party from committing a breach it will be called a ‘penalty’. And under English law a clause which seeks to impose a penalty is unenforceable. The general rule has always been that a court will decide things based on the situation at the time you entered into the contract.

Facts:

In this recent case a contractor (C) had tendered for a construction project. In order to position itself to do so it entered an agreement with a sub-contractor (SC). This said that if the tender was successful C would put SC on the job, which would pay SC $75m; and that if C failed to do so it had to pay SC liquidated damages of $40m, which the contract said was proportionate and a genuine pre-estimate of the loss that SC would suffer if it was not appointed.

But some time later S and SC amended the agreement. One change was that the job would be worth $55m to SC, and not $75m as before. But they didn’t change the liquidated damages clause.

Guess what: C won the tender, but didn’t appoint SC as sub-contractor. So SC sued.

Decision:

The court ruled that although the liquidated damages clause was ok when the original contract was signed, when the contract was amended the $40m turned into a penalty. The court chose to decide things based on the situation at the time the contract was amended.

Advice:

Be very careful with any liquidated damages clause to avoid it being treated as an unenforceable penalty.

Be very careful if you amend a contract some time after it is originally signed. If the situation has changed, you may need to think about amending any ‘liquidated damages’ clause along with any other clauses you are changing.

Case: Unaoil Ltd v Leighton Offshore Pte Ltd [2014]