Commercial and legal aspects of

liquidated damages and penalties

W.K.Amila Gayan

B.Sc. (Hons.) in QS, LLM (Cons.Law & Arbi.), FCIArb., MRICS, AIQS(SL)

Commercial Manager - Al Turki Enterprises LLC

Chartered Quantity Surveyor/Board Member of RICS MENA Construction & QS Working Group/ RICS and IQSSL APC

Counsellor/Supervisor

Presented in a CPD organised by Australian Institute of Quantity Surveyors –Oman Branch on 15 June 2015 at Al Maha International Hotel, Oman

Disclaimer

The information contained in this presentation is for education purposes only and should not be considered as legal advice. The information presented should not be acted upon without professional advice.

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Contents Introduction General damages v Liquidated Damages (LDs) LDs v Penalties Calculation of LDs Advantages of LDs LDs in standard forms of contract LDs in GCC countries Case study Conclusion Q& A

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Introduction Contracts bind the parties of the contract to its terms. If one party breaches the terms of contract, the other party may injure/incur losses. Damages, equitable remedies and rescission are the available redress mechanisms for breach of contracts. A breach of contract would cause disputes. It is wise to have provisions to deal with most likely breaches in commercial contracts. Liquidated Damages (LDs) or Liquidated Ascertained Damages (LADs) provisions were introduced to contracts. LDs are genuine pre-estimate of an anticipated loss.

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Introduction

Provision of LDs are now common in construction

contracts. Ex ;- Delay damages, interest on delayed

payment, reimbursement of overtime supervision cost

LDs are widely used to define delay damages i.e. losses

due to delay in completion of projects.

The legal principles applicable to LDs are substantially

differ in common law and civil law countries.

The validity of LD clauses and its enforceability will be

depended on such legal principles.

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General damages v LDs The damages (general/unliquidated) are monetary sum fixed by the courts in order to compensate the injured party for any losses incurred as a result of a breach of contract . Damages are not to punish defendant. Generally punitive damages are not awarded for breach of contract. The purpose of awarding damages is to put the innocent party back in to the position it would have been had the contract been properly performed.

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General damages v LDs

Three important principles that has to be established to be successful in a claim for damages ;

Causation – Loss must be caused by breach Remoteness - Loss must be fairly and reasonably be considered as arising naturally from breach or Contemplation of loss by parties at the time the contract was made as a probable results of the breach Mitigation – Took reasonable steps to mitigate the loss

LD clause in a contract stipulates a specific sum that is payable for particular breach of term of contract. The courts are reluctant to uphold challenges to LD clauses. Freedom of contract/terms of the contract are said to be the law governing the contract.

The whole purpose of LD clause; parties to a contract being able to agree beforehand what damages are to be recoverable in the event of a breach of contract. (Philips Hong Kong Ltd v AG Hong Kong, Privy Council Appeal No.29 of 1991 (1993) 61 BLR 41)

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LDs v Penalties In English legal system and most of other common law countries LD provision will be invalid if it proves to be a penalty. Generally punitive damages are not available for breach of contract. Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] UKHL stated ;

The essence of penalty is payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage.

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LDs v Penalties

The judge in Jeancharm Limited v Barnet Football Club Limited [2003] EWCA Civ 58 mentioned four important principles to be considered to determine whether LD clause is a penalty;

1. the court looks at the substance of the matter, rather than the form

of words, to determine what was the real intention of the parties;

2. the essence of a penalty is a required payment in terrorem of the party in default, as distinct from being a genuine pre-estimate of loss resulting from the default;

3. the question whether a provision for payment on default is a penalty is a question of construction of the contract, and that is assessed at the time of the contract and not at the time of the breach;

4. if the required payment is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be established as the consequence of a default, it is a penalty.

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Calculation of LDs LDs are genuinely estimated amounts of potential loss arising out of breach of contract. Estimation of such amounts has to be carefully calculated which otherwise LDs may consider as penalties. “It is recommended that calculations for liquidated damages are thoroughly considered by the employer and the quantity surveyor/project manager and a detailed record of the final value retained in case they are challenged at a later date.(” RICS Guidance Notes in Damages for Delay to Completion, 2011) QSs will have a major role to play in LD calculations as a professional involved in the pre-contract stage. Even though calculation of LDs has to be done as accurate as possible, the courts will not decide LDs as penalties if LD amount exceeds the actual loss.

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Calculation of LDs

In Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] BLR 271 (TCC), the judge stated;

a pre-estimate does not have to be right in order to be reasonable. There must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered before it can be said that the agreed pre-estimate is unreasonable.

Major elements to be considered in calculation of LDs;

1. Loss of revenue/return on the investment. 2. Supervisory cost. 3. Loss due to extending finance cost. 4. Other miscellaneous cost.

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Calculation of LDs

Loss of revenue/return Hotels

loss of revenue of rooms & other facilities (restaurants, leisure facilities, banquet halls etc)

Occupancy levels based on seasons or special occasions

Running costs (utility consumption, cleaning, laundry, employees cost etc) to be deducted

Office blocks/residential units

To occupy-cost of leasing alternative building/accommodation

To lease – loss of revenue/rent

Retail buildings Expected return/profit Revenue in seasonal periods

LDs can be calculated for sections/milestones.

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Advantages of LDs

Force the parties to not to breach contract terms

Financial certainty of consequences of breach of

contract

Accordingly risk can be allocated

Limitation of liability

Non-defaulting party can recover the loss without the

difficulty and expense of proving actual loss

No legal costs since loss can be recovered under the

contract

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LDs in Standard Forms of Contract

FIDIC 99 Suit of Contracts (CONS, P & DB and EPCT)

Clause 8.7 – Delay Damages

If the Contractor fails to comply with Sub-Clause 8.2 [ Time for Completion ], the Contractor shall subject to Sub-Clause 2.5 [ Employer’s Claims ] pay delay damages to the Employer for this default. These delay damages shall be the sum stated in the Appendix to Tender, which shall be paid for every day which shall elapse between the relevant Time for Completion and the date stated in the Taking-Over Certificate. However, the total amount due under this Sub-Clause shall not exceed the maximum amount of delay damages (if any) stated in the Appendix to Tender. These delay damages shall be the only damages due from the Contractor for such default, other than in the event of termination under Sub-Clause 15.2 [ Termination by Employer ] prior to completion of the Works. These damages shall not relieve the Contractor from his obligation to complete the Works, or from any other duties, obligations or responsibilities which he may have under the Contract.

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LDs in Standard Forms of Contract

FIDIC 99 Suit of Contracts (CONS)

Employer shall submit Employer’s Claim as per Clause 2.5 for Delay Damages.

Engineer will then make a determination under Sub-Clause 3.5. whether Employer is entitled to deduct an amount as delay damages.

it can be deducted from Payment Certificates in accordance with Clause 2.5.

If a Taking-Over Certificate is issued for part of the works (Clause 10.2) , the delay damages are reduced for the remaining works, assuming they are not delivered within the time for completion.

The proportion of reduction is calculated based on a pro-rata of the value of the works certified. This will not have any effect in reducing the maximum liability for damages stated in the Appendix to Tender.

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LDs in Standard Forms of Contract

Standard Documents for Building and Civil Engineering Works 1981

Clause 47.1 – Penalties for Delay If the Contractor shall fail to achieve completion of the Works within the time prescribed by Clause 43 hereof, or such extended time as may be allowed under Clause 44, hereof, then the Contractor shall pay to the Employer the sum stated in the appendix to the Tender as a penalty for such default for every day or part of a day which shall elapse between the time prescribed by Clause 43 hereof or the extended time as the case may be and the date of certified completion of the Works. The Employer may, without prejudice to any other method of recovery, deduct the amount of such penalties from any monies in his hands due or which may become due to the Contractor. The payment or deduction of such penalties shall not relieve the Contractor from his obligation to complete the Works, or from any other of his obligations and liabilities under the Contract.

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LDs in Standard Forms of Contract

Clause 47.2 – Reduction of Penalties If, before the completion of the whole of the Works any part of section of the Works has been certified by the Engineer as completed, pursuant to Clause 48 hereof, and occupied or used by the Employer, the penalties for delay shall, for any period of delay after such certificate and in the absence of alternative provision in the contract be reduced in the proportion which the value of the part or section so certified bears to the value of the whole works. Standard Documents for Building and Civil Engineering Works 1999

Clause 47.1 – Penalties for Delay If the Contractor shall fail to achieve completion of the Works within the time prescribed by Clause 43 hereof, or such extended time as may be allowed under Clause 44, hereof, then the Contractor shall pay to the Employer the sum stated in the appendix to the Tender as a penalty for such default for every day or part of a day which shall elapse between the time prescribed by Clause 43 hereof or the extended time as the case may be and the date of certified completion of the Works provided such sum does not exceed 10%.

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Few more important aspects of LDs

If the amount in Appendix to the Form of Tender “Nil” for LDs?

The employer may lose the right to impose any damages for breach. (Temloc Ltd v Errill PropertiesLtd [1987] 39BLR34 CA) If the amount in Appendix to the Form of Tender left blank for LDs?

The employer may lose the right to impose LDs for breach but may get general damages. [Gilbert-Ash (Northern) Ltd v Modern Engineering (Bristol) Ltd [1974] AC689 HL] Can the employer impose LDs even if he has not incurred actual loss?

They employer may deduct LDs from contractor even there is no actual loss. [BFI Group of Companies v DCB Integration Systems Ltd (1987)] Who has to prove LDs are penalties in a challenge for LDs?

The contractor will have to prove that LDs are penalties in a challenge to a LD provision in a contract. (Philips Hong Kong v The Attorney General of Hong Kong (1193).

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LDs in GCC Countries

Article 390 of the UAE Civil Code states that:

(1) The contracting parties may fix the amount

of compensation in advance by making a

provision therefore in the contract or in a

subsequent agreement, subject to the

provisions of the law.

(2) The judge may in all cases, upon the

application of either of the parties, vary such

agreement so as to make the compensation

equal to the loss, and any agreement to the

contrary shall be void.

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LDs in GCC Countries

Dubai Court of Cassation judgment 138/94

The case was about a dispute between contractor and

his subcontractor regarding delay in completion of

supply and installation of doors.

Penalty clause for delay in completion

Claimant sought full penalty

Court exercised its right under Article 390 of civil code

to review penalty

Actual loss was less than agreed damages

Court awarded only actual loss suffered

Penalty and LDs were considered equally and there

was no pure distinction drawn to difference between

the penalty and LDs

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LDs in GCC Countries

Article 265 of the Qatar Civil Code states that:

If the object of an obligation is not a sum of money, the contracting parties may determine in advance the value of the compensation in the contract or in a subsequent agreement. Article 266 of the Qatar Civil Code states that: The agreed compensation will not be payable if the debtor shows that the creditor has not incurred a loss. The court may reduce the compensation from what is agreed if the debtor shows that the determination is grossly excessive or that the obligation has been partially fulfilled. Any agreement to the contrary will be void.

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LDs in GCC Countries

Article 267 of the Oman Civil Code states that:

(1) If the subject matter of obligation is not a sum of money, the contracting parties may determine the amount of compensation in advance by making a provision of the same in the contract or in a subsequent agreement. (2) In all cases, the court may, upon the application of either of the parties, amend such agreement to make the compensation equal to the damage, and any agreement to the contrary shall be null and void. Experts argue that the basic purpose/advantage of LDs i.e. the certainty or agreed pre-estimated amount, given by such clause is diminished by court interference.

At the same time others argue that such rules do the justice to situations where there are no actual losses incurred and the defaulting party is still liable to pay LDs.

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Case Study

Contract was in bespoke contract conditions.

Contract specified ;

Working Hours for Site Contractor shall include for working normal Employer’s hours:- 07.00 to 16.00, 1 hour Lunch break, Saturday to Wednesday inclusive Should Contractor require to work outside these hours then prior arrangement must be sought from Employer and no additional payment will be made.

Contractor had worked outside the working hours specified and the Employer claimed their Consultant’s supervisory charges from the contractor.

The recovery of consultant’s supervisory charges disputed by the contractor. .

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Case Study

A proper LD clause in such a scenario would have been;

.

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Case Study

In such a case, the contractor would have incorporated a sum for such supervisory fees as per the construction program.

Employer wrote to contractor referring following clauses of the contract, that he is responsible for additional cost.

Rate of progress If for any reason directly or indirectly attributable to Contractor, Employer is of the opinion that progress of the Work is delayed or progress is not being maintained on items which, if no actions were taken, would affect the ability of Contractor to achieve Substantial Completion Date and/or Completion Date, Company shall notify Contractor that it has failed to ensure the execution of the work and Contractor shall within seven (7) calendar days from the date of the notice take all steps as are necessary, subject to the consent of Employer or, in the event of failure to do so, shall take such reasonable steps as Employer may instruct in writing to expedite progress so as to correct such deficiencies in the execution of the Work as specified in the notice from Employer. Contractor shall not be entitled to an extension of time and/or additional cost for taking such steps. If any instruction issued by Employer pursuant to this sub-article causes Employer to incur additional costs, such costs shall be recoverable from Contractor by Employer and may be deducted by Employer from any monies due or to become due to Contractor.

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Case Study

Right to recover cost Where Contractor is in default or, through no fault of Employer, exceeds

the maximum duration for application of the penalty, referred to in

Article ….., and regardless of whether or not Employer shall have

imposed penalties, Employer shall be entitled to recover from

Contractor costs incurred by Employer as a result of this. In addition,

Employer shall have the right to impose any other penalties as set out

elsewhere in the Contract.”

Contractor argued that;

It is the Contractors position Clause for Rate of Progress deals with situations where completion on time is at risk and the Employer expressly notifies and instructs the Contractor to take specific recovery measures. It is the Contractors position aforesaid clause does not provide a blanket entitlement to the Company to contra charge supervision costs that the Company incurs.

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Case Study Contractor argued that;

The Employer shall prove that additional supervisory cost is directly due to out of working hours.

The contractor is in delay due to his culpable delay.

Employer must prove that those overtime charges are not covered under delay damages defined in the Contract and actual damages due to such delay are over and above the LDs which has been already imposed under the Contract.

Employer needs to demonstrate that its costs exceed that LDs otherwise Employer is seeking to achieve double recovery and unjust enrichment.

This case clearly illustrates;

The advantages of having proper LD provision in contracts.

The difficulty in getting damages for breaches under the contract when it is not specified.

Importance of correct reference to provision of contract for a particular issue.

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Conclusion

Damages are one of available remedy for breach of contracts and when it genuinely pre-estimated at the time of entering in to the contracts it could be a LD.

Once the LDs are far exceeding and unconscionably higher than the loss for a particular breach that could have been estimated, it may construe as a penalty.

Penalties are not enforceable under most of common law systems.

It is important to estimate LDs as accurate as possible.

In some standard conditions of contracts, certain conditions of precedent to be followed to establish correct LD claim.

The law applicable to LDs in GCC countries is substantially different than common law.

Such legal provisions allow courts to adjust agreed LDs/Penalties to actual loss suffered. .

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