Guest editor Vijay Bange of Trowers & Hamlins supports the recent evolution in the use of liquidated damages that makes it wise for contractors to speak to clients before making key project personnel changes.
Liquidated damages are a common concept in construction contracts. The tussle as to whether they amount to a penalty has been up for discussion in the context of variations to the contract price. The concept has evolved further from the traditional delay scenarios they are common in, and we have now seen their application in the context of change in key personnel on a project.
Anyone that has made, or been subject to, a claim for liquidated damages will be familiar with the well-established principle that the contractual rate of those damages needs to be a genuine pre-estimate of the employer’s loss at the time of entering into the contract. If the employer does not properly estimate its losses and simply proceeds to insert an arbitrary rate of damages, the clause may well fail on the basis that the sum claimed is not an actual reflection of the employer’s loss. In short, that it does not represent a genuine pre-estimate of loss. Rather it may be designed as an intimidation tactic aimed at getting the contractor to pay up in terrorem.
The approach of the courts
The courts have not looked favourably on employers taking this approach. More often than not the courts will deem liquidated damages clauses of this type a penalty provision and therefore render them unenforceable. How does the court decide whether the clause is a penalty? It applies an objective test. It considers whether the contractual rate is unconscionable, or extravagant or exorbitant against the employer’s real estimated losses. A test that has been applied for 100 years since the Dunlop case of 1915. More recently, the courts have also started to consider whether the level of damage is reasonable.
It is not enough however to only consider that estimate at the time of making the contract. Where contractual amendments are made further down the line parties should revisit the estimate to check that it still represents a genuine pre-estimate of loss after taking the amendments into account. If it doesn’t, then there is a risk of the liquidated damages clause becoming unenforceable on the basis that it is a penalty. Perhaps the most obvious circumstance in which this may arise is where there is an amendment to the contract sum.
Recent case law
In Unaoil Ltd v Leighton Offshore Pte Ltd [2014] EWHC 2965 (Comm), the court said that where the contract sum had been reduced from $75m to $55m, the original pre-estimate of loss agreed by the parties in the sum of $40m was no longer proportionate and unlikely to still be a genuine pre-estimate as no account of the reduced contract sum had been given. The claim was rejected. The liquidated damages clause failed. It was held to be unenforceable and a penalty.
The application of this principle is probably fairly limited in traditional construction contracts. The facts in Unaoil were particularly unusual. The liquidated damages became payable, not in the event of contractor delay, but in the event that the sub-contract was not awarded to Unaoil. The liquidated damages were calculated directly on the lost profits suffered by Unaoil of not being awarded the work. In order for this principle to be applied in a wider construction context, there would probably have to be a significant amendment to the contract.
Proceed with caution
As a matter of caution, to protect themselves, parties should make sure that they revisit and if necessary amend the liquidated damages provision if the contract is amended in such a way that it may affect the pre-estimate of loss. Where there are significant contract amendments, the relevant date for assessing the pre-estimate becomes the date of the amendments and not the date of the contract.
It is not uncommon in construction projects for personnel to change over the course of the works. Whilst a change in key personnel can be frustrating and has the potential to cause some upheaval, not many employers would expect to be compensated for that change.
However, in Bluewater Energy Services BV v Mercon Steel Structures BV [2014] EWHC 2132 (TCC), the contractor got exactly that from its sub-contractor. The sub-contract provided that the contractor was entitled to receive liquidated damages for each key personnel change unless otherwise agreed with the contractor. The rate of those damages was dependent on the level of seniority at which the change was taking place.
The contractor sought to claim liquidated damages for four instances where it had not given its prior approval for the change. The sub-contractor resisted payment on the basis that the liquidated damages were a penalty and therefore unenforceable. The court did not accept this as a defence. It was held that key personnel were fundamental to the successful performance of the contract and that any such change could cause ‘a great deal of disruption’. The parties had freely agreed a fixed sum of damages to cover that.
Evolution
Unaoil is a trap for the wary. However, Bluewater is more evolutionary in the development of the application of liquidated damages to changes in key personnel. This is welcomed as often problems derive from changes in key site people and the break in continuity of an individual(s) who has ownership and carries this through to completion of the project. Regular comings and goings of people in the know, with the knowledge and understanding of the project, can easily be the root cause of things going wrong.
A shift in personnel has real potential to lead to a lack of consistency and problems with performance. Whilst it’s not easy to quantify the loss and damage arising as a consequence, trying to agree an estimate of the losses arising from such changes makes a refreshing change. What’s more is that the courts have endorsed it. Project personnel taking ownership and responsibility for a project helps make for a smooth running contract. Maybe Bluewater will make contractors think twice before switching the project personnel without first discussing it with the employer.
The courts are loathe to interfere with bargains entered into between commercial entities. What is refreshing is the endorsement of innovative thinking in this instance. The development of such mechanisms will avoid potential disputes over liability and quantum in circumstances where it is common sense that a loss will ensue from the ins and outs of key personnel.
The evolution in the court’s thinking behind the application of liquidated damages should give commercial parties greater incentive to make more use of these provisions. If used properly, liquidated damages give an employer certainty on the consequences of certain breaches by the contractor. An employer knows how much he will get, does not have to prove loss and can usually make a deduction for what he is owed from payments due to the contractor.
Contractors also benefit by knowing the extent of its liability for those breaches enabling it to price its risk early on. The construction industry suffers from inefficiencies and is rife with disputes. The use of innovative mechanisms utilising pre-agreed loss and damage provisions may avoid the need for formal legal proceedings in bringing a claim to prove general damages and protect the parties from incurring what could be significant legal costs. Although there has been a resurgence in the construction market, cost saving measures are still very much at the forefront of parties’ minds and liquidated damages could assist parties in working more efficiently and reducing risks.