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Genuine pre-estimate loss or penalty? Have the rules changed?

24 October 2014 #Corporate

The parties to any contract can deal with the effects of breach of contract claim in a number of ways.  For example, the contract may leave the issue of the determination of damages for breach of contract to the court.  Alternatively, parties may choose to clarify, restrict or fix losses.  They are common in construction and engineering contracts to cover the issue of delays.  This avoids the need for complicated and lengthy court proceedings and allows the damages to be paid and contact to continue.  Payment may be by deduction from the contract sum.

If losses are fixed at the time that the contract is entered into (frequently called liquidated damages or liquidated and ascertained damages) then care must be taken to ensure that they are a genuine pre-estimate of the loss that would be suffered on the occurrence of a particular event.  If they are not, and the court views them as a penalty, they will not be enforceable.

Whilst the court does not expect the parties to be entirely accurate, there must be a genuine attempt at pre-estimating the loss in order for a court to be prepared to hold the clause a valid one.  If an arbitrary figure is chosen then it is possible it may be open to challenge at a later date. 

The genuine pre-estimate can only occur at the times that the contract was entered into.  The matter came before the commercial court in the case of Unaoil Limited v Leighton Offshore Pte Limited earlier this year, with a judgment being published on 22 September.  In that case, liquidated damages were set out in the contract.  The contract sum was subsequently varied downwards, from $75 million to $55 million by an amendment to the contract. 

A number of questions came before the court, one of which was whether or not liquidated damages had to be paid.  The court held that the liquidated damages claim failed on the basis that it was an unenforceable penalty.  In making its judgment, the court looked at the case of El Makdessi v Cavendish Square Holdings BV in 2013, and the court listed out the matters to be considered when ascertaining whether a clause is a genuine pre-estimate of loss or in fact a penalty, namely: 

  1. Whether the figure was a reasonable estimate of the likely recoverable loss of the innocent party.
  2. Sums exceeding the maximum possible loss may be an indicator of a penal provision.
  3. If the genuine pre-estimated loss exceeded the amount that was likely to have been recovered by an innocent party in a normal damages claim then this is also likely to be a penalty as it would not cover solely recoverable losses.

Having looked at the various issues, the court noted that, whilst the assessment should be made as to whether or not the sum was a genuine pre-estimate at the time the contract was entered into, in some circumstances subsequent factors could be taken into account.  In this case, the contract was varied, and the contract sum was varied downwards.  The court took the view that the liquidated damages should also have been amended at that point to take account of the reduced contract sum.  The court therefore took the view that the date of the relevant contract against which the liquidated damages should be assessed, was the amended contract, not the original contract.  As such, they considered that the clause was a penalty and thus unenforceable.

It is therefore important, when considering variations to contracts, to ensure that the effect of those variations is properly considered across all matters such as liquidated damages and the enforceability of, for example, pre-existing parent company guarantees.

Clarkslegal, specialist Corporate lawyers in London, Reading and throughout the Thames Valley.
For further information about this or any other Corporate matter please contact Clarkslegal's corporate team by email at by telephone 020 7539 8000 (London office), 0118 958 5321 (Reading office) or by completing the form on this page.
This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full General Notices on our website.

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