Reading through a judgment the length of Bluewater Energy Services BV v Mercon Steel Structures BV and others is no mean feat. Luckily for the brave and steadfast, the case considers a number of core issues that arise time and again in construction contracts and raises some interesting questions. One example that caught my eye was the analysis of liquidated damages (LADs) levied for the replacement or removal of key personnel.
LADs are not always about extra time
The dispute arose out of a sub-contract made between the claimant main contractor (Bluewater) and the defendant sub-contractor (Mercon). In addition to the usual delay LADs, the bespoke form of sub-contract also applied LADs if the sub-contractor replaced key personnel without obtaining the prior approval of the main contractor. The LADs applied to specified key personnel and ranged from EUR20,000 for the HSE engineer to EUR50,000 for the project manager.
The fact that LADs of this kind are unusual is, in itself, no barrier to their enforcement. In a construction context we are all familiar with LADs being applied in relation to delay and performance shortfalls. Parties to a contract are also free to agree in advance the damages that will be payable on the occurrence of other events and LADs are a commonly used contractual tool in many other arenas. An example, often discussed in the press, are the payments made to football managers when they fail to meet their supporters’ ambitions and are themselves given the boot (not the golden kind!). To continue the footballing theme, the question that will ultimately determine whether such payments are enforceable is not what triggered them, but whether they constitute a penalty.
In the Bluewater case, Mercon argued that the key personnel LADs were a penalty and therefore unenforceable. Ramsey J disagreed. The rationale for the LADs was not entirely clear to me, so I had some sympathy with Mercon. The fact is that employees move on and employers cannot stop them from doing so. Mercon argued that the LADs constituted an un-commercial mechanism, restraining it from dealing with its personnel in the proper exercise of its business. However, on the question of whether the LADs were unduly restrictive and therefore penal, Ramsey J thought not.
He considered that the key personnel were central to the successful performance of the contract and that Bluewater’s ability to approve or disapprove of their replacement was an important safeguard for the proper performance of the contract. I wasn’t entirely convinced by this. It is clear that the sub-contract was bespoke, keenly negotiated and expressly addressed failures in performance by the sub-contractor. While changing key personnel may ultimately cause some disruption, the consequences of this were addressed by other remedies available under the contract, not least delay LADs.
In addition the judge did not consider the value of LADs to be unconscionable in terms of being extravagant or exorbitant, regardless of the fact that they probably equated to a significant proportion of the professional’s annual salary. This contrasts with the decision in Fitzroy Robinson Ltd v Mentmore Towers Ltd where Coulson J found that there was no basis for assessing a reduction in fee as a consequence of a change in key personnel that had not been communicated to the client.
However, the key factor in this case was timing. Whether a contractual provision is a penalty or not must be judged at the date of the contract in question. If it is not penal at that date, it cannot become a penalty when subsequent events transpire. At the time of entering into the contract the evidence showed that the parties had negotiated the LAD rates and had considered the possible loss caused by disruption to the works by replacing key personnel. LADs provide certainty to both parties in commercial relationships: they allow the parties to fix the compensation payable by one party to the other in the event of a specific breach of contract and while hindsight may show that a party has not sustained a loss equivalent to the liquidated sum, that is the risk that the parties take in agreeing the liquidated sum at the outset.
The fact that Bluewater could not quantify the loss that it would suffer as a result of changes to key personnel at the time of the negotiations was no obstacle to the sum stipulated being a genuine pre-estimate. On the contrary, it is widely recognised that this is just the situation when it is more probable that the pre-estimated amount was the true bargain between the parties.
LADs that do not apply to delay or performance shortfall and which may sit alongside other contractual remedies are more open to challenge. An example that we often see in a construction context is LADs covering damage to reputation. This is equally difficult to quantify but, in itself, will not result in the LADs being penal. Even when a contractual term provides for excessive payment on breach, that may be valid if it has proper commercial justification. The Bluewater case re-affirms the courts’ reluctance to stand in the way of the bargain the parties have agreed and the “default” position that LADs in commercial contracts should normally be upheld.
For the draftsmen amongst us, it is a useful reminder of the importance of:
- Carefully considering the specified amount or rate of LADs in contract negotiations, especially if they do not relate to delay or performance shortfall (which are, for the most part, easier to quantify).
- Where possible, being able to evidence any discussions and agreements that take place in relation to them.
This article was first published by Practical Law Construction as part of our regular construction blog series in which we share our practical experiences of working in construction and engineering and give our opinion on the current and future legal developments that shape and will shape the industry. To read more from the series, visit the Practical Law blog.