LADs: Sharing the pain

In January, Ann Minogue hoped that this year “we avoid a torrent of cases about penalty clauses” (7 January 2014). We have now seen three such cases in 10 months.  Two of them are rare instances of the courts striking down liquidated and ascertained damages (LADs) provisions. However, despite appearances, LADs clauses are increasingly supported.

Tony Bingham covered the most recent case, Unaoil vs Leighton, on 26 September. Leighton’s contract required it to pay LADs of $40m if it didn’t subcontract to Unaoil certain oil pipeline work. The relevant clause was struck down because it was “extravagant and unconscionable with a predominant function of deterrence, without any other commercial justification”.  That was even if one took the most favourable view of the evidence that by not getting the subcontract Unaoil lost out on a stonking $33m profit. That still left an unjustified $7m in LADs.

A similar test was applied in the other recent case to strike down a LADs clause.  The contract in Makdessi vs Cavendish was for the sale of shares in an advertising company.  The relevant clause said that if the seller breached certain covenants, he would get nothing for shares he had already transferred and his remaining shares could be bought at a reduced price.  Without the clause the buyer was entitled to nothing.  With it, the buyer, like Unaoil, unjustifiably gained millions of dollars.  

Without the clause the buyer was entitled to nothing. With it, the buyer unjustifiably gained millions of dollars

The third case (Bluewater vs Mercon) concerned a construction contract originally for €10.5m.  The court awarded LADs of €150k that were due when key personnel named in the contract were changed without consent. Mr Justice Ramsey held that, while it had not been possible precisely to quantify the disruption from unapproved new personnel, the LADs of €20-50k per person were not unconscionable, extravagant or exhorbitant.

To put these three cases into context it is worth recalling that the main aim of LADs clauses is to avoid having to prove the loss resulting from a given breach, be it late completion, non-compliant work or otherwise. Challengers sometimes forget that if LADs clauses are struck down, the innocent party can recover its proven losses. However, in practice the innocent party may not prove its actual losses - giving the court an invidious choice between awarding LADs or nothing at all.

Many jurisdictions avoid that choice by empowering their courts to award more or less than the LADs depending on the circumstances prevailing when there is a breach. In fact, in some jurisdictions (such as Qatar and the UAE) the dislike of LADs clauses telling their courts how much to award is such that if a lower actual loss is proven, that is awarded instead. 

The other aim of LADs, in theory at least, is to limit the sum that the party in breach pays. In practice, though, this is rarely seen as a benefit by that party, if it is a benefit at all.  

The test now applied diminishes this aspect.  It is less concerned with whether the LADs were a genuine pre-estimate of likely loss when the contract was made (or amended, as in Unaoil). The key factors are unconscionability, extravagance, oppression, exhorbitance, predominant function of deterrence, lack of commercial justification and the parties’ relative bargaining power.

If the LADs weren’t a genuine pre-estimate that goes to the first few factors listed above, but is not decisive. However, it is often not possible to pre-estimate the likely loss. Also there is often a range of likely losses. In short, the new test invites those who include LADs in their contracts to go higher than they might have before. It also promotes zero-tolerance completion clauses, whereby delay LADs apply even if there are minor snags or missing documents.

Given contractors’ tight margins, it often takes only a few weeks of delay LADs for their entire profit for a project to disappear. While the default threshold for extensions of time is low, in practice the result often seems, as with LADs, to be all or nothing, as I explained in my article of 20 June. Bluewater can be added to the cases I considered then as another example where no extensions of time were granted for long over-runs.

The new test should incentivise contractors to provide for LADs in subcontracts. To date there has been a reluctance to do so given the difficulties of pre-estimating the loss caused by a given subbie’s delay. That reluctance may weaken. While the number of penalty clause cases should reduce, the pain caused by LADs clauses seems set to increase.

Rupert Choat is a barrister, mediator and arbitrator at Atkin Chambers.