A court struck down a liquidated damages clause because when the value of the contract was reduced, it became disproportionate and ‘unconscionable’

Tony Bingham

Liquidated & ascertained damages (LAD) clauses, said my law lecturer all those years ago, are a highly convenient contractual tool to make life easier and more predictable. Mind you, this fella was also a member of the Flat Earth Society. Bonkers! Liquidated damages clauses for delay are in my humble opinion the bane of a constructor’s life. Bonkers! Liquidated damages clauses – especially the ones that bash people for being late - are the very best ingredients to fire up the disputes game. Builders, who look at the daily, weekly damages money figure, describe them as a penalty clause, then squeal for extensions of time to defeat the penalty. The builder blames the architect, the engineer, the archangel Gabriel and Lucifer for delays, to say nothing of snow in winter. The employer has a glint in his eye at the rate per week bonus he can cop if he can bully the architect into giving zero extension of time. Oh yes, it’s a great game in the construction contract disputes world. I love it.

A recent case struck down the liquidated damages clause. It was a whopper. I will tell you the circumstances. Note first though, the test for booting it out: show that the clause in the contract was “extravagant and unconscionable with a predominant function of deterrence” rather than being a genuine pre-estimate of the loss likely to be suffered in the event of a broken promise. I bet this test gets the lawyer licking his lips. The fun bit is showing that the LAD clause has a “predominant purpose” of frightening the hell out of the other bloke: and to put the frighteners on the builder. It’s a loaded 12-bore, isn’t it? Be late and I will blow your head off. Big subcontractor Unaoil Ltd, big contractor Leighton Offshore PTE Ltd joint-tendered for some big construction works.

The fun bit is showing that the LAD clause has a ‘predominant purpose’ of frightening the hell out of the other bloke: and to put the frighteners on the builder

Their joining together was via a side deal whereby Leighton would be the bidder for the main contract. And if Leighton came top in the lottery, Unaoil would be Leighton’s key construction works subcontractor. That’s simple enough in anyone’s language. But just to make sure that everyone played by the rules, some bright spark had the idea of putting into the side deal a liquidated & ascertained damages clause. It wasn’t a LAD clause for delay, no, no - you can use a LAD clause in the contract for any broken promise you can think of. Leighton agreed via the LAD that if, just if, they eventually decided not to form a warm and loving subcontract with Unaoil, the LAD clause would kick in. The kick? £25m payout to Unaoil - Wow! This was in return for not placing the subcontract worth £45m and having a share in the £450m main contract. It was commerce rather than the law that now took a hand. The subcontract was indeed placed but not for £45m; it was for £32m.

Dear me, said one of the lawyers for Unaoil, that means Leighton has broken its promise. It failed to place a £45m subcontract, so that triggers the £25m LAD clause. I bet that made everyone very warm and cosy again. Leighton argued the toss. It wanted to get out of the LAD clause. It all came to court last week: Unaoil Ltd vs Leighton Offshore PTE Ltd. Leighton said that the LAD clause was now a penalty so it should be struck down.

The principle is that a contract cannot impose a penalty clause. It is a rule of law: “Penalties are a blatant interference with freedom of contract.” Any attempt to design a compensation clause must be founded on a “genuine pre-estimate of the loss which the innocent party will incur by reason of a breach.” The burden of proving it is a penalty is on the party making the assertion. The court is generally reluctant to find that a clause is penal, especially if the parties are of equal bargaining power and have had the benefit of legal advice. The modern test is whether the LAD clause in question is “extravant and unconscionable with a predominant function of deterrence and even if that is demonstrated, that there was no other commercial justification for the clause”. The outcome of the case is that the broken promise made the LAD of £25m a disproportionate sum and therefore a penalty.

So it was struck down.

Unaoil was awarded damages for the repudiatory breach by Leighton. It was calculated by “loss of chance rules” (in other words, loss of chance to make a profit). A neat reminder of that rule when quantifying the loss is rehearsed in the case. It is not to apply what the lawyers call the balance of probability test to the proof of past facts; rather the position is to estimate the loss by making a best attempt to evaluate the chances, great or small, of the loss. Now you’re talking; it sounds like an industry stab at an estimate rather than a lawyer piece of black art.

Tony Bingham is a barrister and arbitrator at 3 Paper Buildings, Temple