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

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.

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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