Saturday, October 25, 2014

Revisiting penalty clauses in contract

Last year, the English Court of Appeal in Talal El Makdessi v Cavendish Square Holdings [2013] EWCA Civ 1539 considered the enforceability of penalty clauses under English contract law, and was one of the few decisions in recent times to have concluded that the clauses in question were penal and therefore unenforceable. The decision was notable for affirming that the English law rule against the enforceability of penalty clauses applies not only to clauses requiring a payment to be made by a defaulting party, but also to (i) clauses permitting the innocent party to withhold a payment from the defaulting party, and (ii) clauses requiring the transfer of assets from the defaulting party to the innocent party at a reduced price. Both of these propositions are not entirely settled under English law, with no conclusive House of Lords / Supreme Court decision on either point.

The other point of interest arising from the case was a reference in Clarke LJ's leading judgment to a significant anomaly at the foundation of the English law on penalties – it doesn't cover clauses which apply when there has been no breach of contract. To borrow the illustration used by Heath J way back in 1801 in Astley v Weldon (1801) 2 Bos. & P. 346, "It is a well-known rule of equity, that if a mortgage covenant be to pay £5 per cent. and if the interest be paid on certain days then to be reduced to £4 per cent. the Court of Chancery will not relieve if the early day be suffered to pass without payment; but if the covenant be to pay £4 per cent. and if the party do not pay at a certain time it shall be raised to £5 there the Court of Chancery will relieve". This anomaly provides latitude for draftsmen to avoid the rule against penalties, and has led to calls from leading academics (including Edwin Peel in the July 2014 issue of the Law Quarterly Review) to call for the abolition of the rule against penalties. It is however interesting to note that a 2012 decision of the Australian High Court (Andrewsv Australia and New Zealand Banking Group Ltd [2012] HCA 30) addressed this anomaly by applying the rule even when there has been no breach of contract and the Indian position has been discussed by Niranjan in a previous post.  

In May this year, the UK Supreme Court granted leave to appeal from the Court of Appeal's decision in Cavendish and the outcome of that appeal will be of great interest (although it is not clear whether the rule against penalties is a subject of the appeal, since the decision also involved findings on two other claims).

However, in the meanwhile, the English High Court last month decided another interesting case in which a liquidated damages provision was held to be penal and unenforceable. Although the facts of Unaoil v Leighton Offshore [2014] EWHC 2965 are rather complicated, the relevant chain of events is easy to summarise. Unaoil, a BVI company which provided a wide range of services across the oil and gas sector, entered into a memorandum of agreement (MOA) with Leighton Offshore in relation to a substantial oil infrastructure project in Iraq. Pursuant to the MOA, Leighton agreed to appoint Unaoil as its sub-contractor in relation to the project, subject to Leighton being appointed by the relevant Iraqi authorities, in consideration for a payment of $70 million. The MOA also contained a liquidated damages clause which provided for the payment of $40 million if Leighton breached the MOA. In particular, the liquidated damages clause stated – "After careful consideration by the Parties, the Parties agree such amount is proportionate in all respects and is a genuine pre-estimate of the loss that Unaoil would incur as a result of Leighton Offshore's failure to honour the terms of the MOA".

Subsequently, there were further discussions as to pricing between Unaoil and Leighton, leading to a supplementary agreement to the MOA pursuant to which the agreed consideration was reduced to $55 million. The liquidated damages clause was left unamended.

Eventually, Leighton was awarded the project but did not appoint Unaoil as its sub-contractor, thereby breaching the MOA as amended. This led to claims by Unaoil on several bases, including a claim for the $40 million payable under the liquidated damages clause. However, the High Court held that the clause was penal and not enforceable. A slightly frustrating aspect of the decision is that the reasoning underlying this conclusion is very brief and leaves a few questions unanswered. It does however lay down an interesting proposition of law, and one for which there was no authority previously.

The rule against penalties does not apply if the amount payable under the contract is a genuine pre-estimate of loss or if it has a commercial justification. However, both these tests are to be applied as on the date of the contract and not on the date of the breach. The question posed in Unaoil however was slightly different, what is the relevant date when the contract has been subsequently amended? The High Court held that- "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 by Supplementary Agreement No. 2, 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". Eder J goes on to state- "The reason why the figure of US$40 million was not reduced at the same time as when the contract price was reduced was not explained. Perhaps it was a mistake or an oversight. I do not know. In any event, 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".
There are aspects to this decision and the underlying reasoning which are not entirely satisfactory, but contracts draftsmen can draw two important lessons from the passages reproduced above:
  • When key provisions relating to the performance timetable and the consideration payable are amended over the course of long term contracts, it is important to assess the impact of the amendments on the liquidated damages clause, if any. Unfortunately, the phrase "in a relevant respect" does not offer much by way of guidance, but one would think that if the amendment is such that it affects the underlying basis of the "genuine pre-estimate of loss" on which the liquidated damages amount has been arrived at, or affects the commercial justification of the clause, the continued validity of the liquidated damages clause should be considered.
  • If on such consideration, it is decided that the amendment to the substantive terms of the contract does not impact the liquidated damages clause (or indeed, even if it does), it may be helpful to document the basis on which the conclusion was reached – perhaps in the preamble to any amendment agreement. In Unaoil, the absence of a sufficient explanation for why the liquidated damages clause wasn't amended played an important role in the decision. It could be argued that this reliance is difficult to reconcile with Clarke LJ's statement of settled law in Cavendish that "The burden of proving that a clause is penal is on the party making the assertion". However, the point does remain that better drafting of the MOA and the subsequent amendment would have avoided a lot of the controversy – in the words of Eder J, “the disputes which are now the subject of the present proceedings are probably due, in large part, to such bad drafting (of the MOA)". 

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