Wednesday, October 9, 2013

"Liquidated damages under UAE and UK law: a comparison"

Liquidated damages under UAE and UK law: a comparison

As we set out in our Introduction, we have recently formed an association with Dubai-based law firm Ahmed Ibrahim. This means that we can offer our clients access to quick, cost-effective multi-jurisdictional advice. And there can be many differences of approach between the Arabic civil code of Dubai and the common law of England and Wales. Here Ahmed Ibrahim and James Mullen discuss the differences in approach relating to delay or liquidated damages.

Liquidated damages in the UAE

Construction contracts commonly provide for a predetermined amount of damages which are to be paid by the contractor in the event of late completion of the works, or possibly specific milestones. This is what is known in the construction industry as liquidated damages (“LDs”) for delay. The existence of LDs in a construction contract is a means of incentivising a contractor to perform in time. It is also an advantage for the parties to avoid the difficulty, time, efforts and expenses involved in assessing the loss which the employer will suffer from late completion. As Ahmed Ibrahim notes, the position of LDs under the UAE law, however, presents a significant degree of uncertainty as to the enforceability of LDs clauses. This may undermine the aforesaid advantages. Dealing with LDs clauses under the UAE law is one of the few areas where the judge may exceptionally intervene to revise the parties’ agreement. This will be illustrated below.

It is worth noting that the Arabic term used, mostly by state courts, for LDs can be translated as “delay fines” or “penalty clause”, and rarely the term “consensual compensation” is also used. This terminology sheds light on an essential difference between the position in the UAE and that in common law countries where the penal nature of LDs is a ground to attack their enforceability. Notwithstanding the terminology, the term “LDs” is commonly used within the industry, given the widespread use of standard forms in the English language in the UAE.

An LDs clause is supposed to set a pre-agreed assessment of the loss which will be suffered by the employer in the event of late completion. Thus, it concerns the quantification of damages as opposed to the liability for damages. The liability for damages is to be generated from the breach of the primary obligation to complete the work in time. Hence, the contractor’s obligation to pay LDs is a secondary obligation.

Consequently, if a construction contract is terminated, the LDs clause automatically becomes valueless. The employer may then claim general unliquidated damages. In this respect the Dubai Court of Cassation stated that:

“delay fines contained in contracts are deemed to be a penalty clause which is a secondary obligation correlated to the primary obligation, and it is a forfeit to the breach of the latter. The ineffectiveness of the primary obligation – as a result of the contract termination – leads to the ineffectiveness of the penalty clause. It follows that the court should not take account of the agreed damages stated in the delay fines clause; the judge may award general damages subject to proof of fault and loss according to the general rules.”1

The legal ground for the parties’ ability to agree the amount of damage in advance is found in Article 390 of the UAE Civil Transactions law (Civil Code) which states:

“1- The contracting parties may fix the amount of compensation in advance by making a provision therefor in the contract or in a subsequent agreement, subject to the provisions of the law.

2- The court may, on the application of either party, vary such agreement so as to make the compensation equal to the loss and any agreement to the contrary shall be void.”

As such, to avoid the payment of LDs, a contractor may challenge the element of “loss”. Article 390(2) entitles the judge to vary the parties’ agreement to reflect the actual loss. This position is repeatedly affirmed and further explained by the UAE courts in considering LDs clauses. For example, the UAE High Federal Court in Abu Dhabi stated that

“delay fines clauses contained in construction contracts are, in substance, no more than an agreed estimate of compensation that would become due in case of the contractor’s failure or delay to perform its contractual obligations. According to Article 390 of the Civil Code, it is not sufficient - for the agreed compensation to become due - to establish the element of fault alone. It should be established, in addition, the element of loss which is suffered by the other party. If the contractor succeeds in establishing the absence of loss, the agreed compensation should be repudiated.”2

Accordingly, the court may set aside entirely the LDs in the unlikely case of the employer suffering no loss from the delay. The court may also award lesser damages reflecting the actual loss. In these two cases, the burden of proof is placed heavily on the contractor’s part. In practice, courts tend not to easily accept the disregarding of LDs; the court would attempt to respect the parties’ agreement and it would not be reluctant to uphold the LDs clause unless it is evident that the LDs considerably exceed the actual loss.

The opposite scenario is to award damages greater than the LDs upon the application of the employer. In this case the burden of proof is shifted onto the employer who should establish the fact that the actual loss exceeds the LDs. This position undermines one of the most important advantages of LDs which is the protection of the contractor against unliquidated damages.

The conclusion is that the uncertainty of LDs causes concerns for both sides; contractor and employer. Attempts to overcome this uncertainty would not work. Article 390(2) expressly states “… and any agreement to the contrary shall be void”.

In the writer’s view, LDs in the UAE should not be looked at from the same perspective as if they were subject to another applicable law, e.g. English law. Courts enforce LDs but there is always room for either party to challenge them; the judge may disregard the parties’ agreement and award compensatory damages according to the general rules of civil law.

Liquidated damages in the UK

Most construction contracts contain a provision for the payment of liquidated damages (“LDs”) in the event of certain specified breaches by a contractor. As James Mullen notes, those within the construction industry in the UK will no doubt be familiar with LDs although it is useful to remind ourselves of a few basic principles, especially in comparison with the civil law approach.

LDs are a predetermined level of damages agreed between the parties which the employer will be entitled to deduct from the contractor in the event of certain specified breaches occurring. LDs benefit both parties to the contract. They offer certainty, limit the contractor’s liability, can save costs in circumstances where proving actual damage can be complex, expensive and time consuming, and they act as a deterrent to breaching the contract.

The parties agree the level of LDs when negotiating their contract. Although not always straightforward, the predetermined level of LDs should represent a genuine pre-estimate of the employer’s likely loss that it will suffer should the specified breach occur. When claiming LDs, the employer does not have to prove that it has actually suffered the loss in the amount stipulated or at all. Further, the employer will be entitled to the amount of LDs stipulated, even if its actual loss is lower. If the level of LDs does not represent a genuine pre-estimate, it may be open to challenge by the contractor later down the line on the grounds that it constitutes a penalty (see below).

Care needs to be taken by the employer when completing the LDs provisions in the contract. Most standard form contracts such as the JCT have an Appendix which includes a section allowing the parties to simply fill in the level of LDs. However, in the past the courts have held that where the parties have completed such a provision by entering “£nil”, they have agreed that there should be no damages for delayed completion, that it constitutes an exhaustive remedy entitling the employer to nil damages and that it is not open to the employer to claim general damages as an alternative.3

The most common specified breach in construction contracts for which LDs will be payable is the contractor’s failure to complete its works on time. The fact that an employer may not suffer any actual loss from the delay does not relieve the contractor from its obligation to complete on time or pay LDs in the event of a delay. However, LDs do not relate exclusively to delay issues and the parties may decide at the contract negotiation stage to apply them to other events of default.

Whilst LDs will usually be an exhaustive remedy for a specified breach such as the failure to complete on time, an interesting question arises as to whether LDs also constitute a remedy where the breach is not the failure to complete on time but some other breach which gives rise to the delay. For example, if the contractor’s work is defective and needs to be remedied, which in turn causes delay, does the LDs provision constitute a remedy for that breach? If, as a matter of construction, the provision appears to be a complete remedy for delayed completion then it does not matter why the contractor failed to complete on time (providing of course that the cause of delay does not give rise to an entitlement to an extension of time or was due to the employer’s default).

Another interesting question is whether a contractor’s liability for LDs continues after the termination of the parties’ contract. The orthodox view by most legal commentators is that LDs will remain recoverable up to the date of termination and general damages for delay will apply thereafter.4

Where there are delays on a project, a contractor may find itself faced with a significant amount of LDs levied against it. In such circumstances it is likely that the contractor will want to challenge the LDs provision in the contract. In reality, given that the parties negotiated and agreed the terms of their contract, the courts are usually reluctant to go against the parties’ agreement. However, there are grounds for the contractor to challenge the LDs being levied by the employer and one of the most common of these is an argument that the amount of LDs constitutes a penalty rather than a genuine pre-estimate of loss and therefore is unenforceable.

Nearly a hundred years ago, the House of Lords in Dunlop v Matthew Tyre Co Limited v New Garage Motor Co Limited5 established a number of principles to help distinguish LDs and penalties. Although these principles have inevitably been refined over the years by the courts, the law on LDs has not been the subject of drastic change and evolution and the basics principles are well established.

If the employer had made a genuine attempt to pre-estimate its loss, the courts are unlikely to judge it to be a penalty. That said, it should be noted that a genuine pre-estimate does not mean an honest pre-estimate. However, where the amount of LDs bears no relation to a loss that could conceivably result from that breach, the courts will not enforce it against the contractor on the basis that it constitutes a penalty. In Alfred McAlpine Capital Projects Ltd v Tilebox Ltd6 the court held that the sum must not be extravagant and unconscionable; although this does not mean that it has to be very similar in amount to the actual losses. The point in time for the assessment of whether a stipulated figure is a genuine pre-estimate or a penalty is when the contract is entered into, not when the delay occurs.

It is always a sensible precaution for an Employer to consider keeping records to show the reasonableness of the final figure agreed for LDs. In Tullett Prebon Group Ltd v Ghaleb El-Hajjali,7 Nelson J. noted that an express contractual statement that there is a pre-estimate or that the sum stipulated is not a penalty is persuasive but not conclusive. In Azimut-Benetti SpA v Healey,8 the trial judge concluded that both parties had the benefit of expert representation in the conclusion of the contract. The terms, including the liquidated damages clause, were freely entered into:

“As the authorities referred to. . .show, in a commercial contract of this kind, what the parties have agreed should normally be upheld.”

Difficulties can also arise where the contract provides for a single sum of LDs but the works are in fact completed in sections or the employer takes partial possession of the works before completion. Unless the contract provides for the division of the single sum between sections or a proportionate reduction for partial possession, it is likely that an employer’s claim for LDs will fail.

In reality, the argument that LDs in fact constitute a penalty is a difficult one to run and where the contractor is challenging the LDs provision, the burden is on it to demonstrate that it constitutes a penalty.

In addition to the penalty argument, other defences available to a contractor to challenge LDs include (but are not limited to): the employer is responsible for the delays, there has been a breach of condition precedents by the employer (for example, a failure to comply with the contract’s certification or notification provisions) and the contractor is entitled to an extension of time.

Challenging LDs can be difficult. However, if a contractor does successfully defend a claim for LDs, the employer is not left without a remedy and it can still pursue a claim for general damages in the usual way. Alternatively, if it is determined that the agreed sum is in fact a penalty, the employer can rely on its claim for the penalty but recover no more than the actual loss which it proves up to the amount of the penalty.

Should a contractor fall into delay, in order to try and protect itself from LDs it should assess whether it has any notification obligations under the contract, whether it may be entitled to an extension of time and the procedure that needs to be followed in relation to this. However, whilst perhaps stating the obvious, the best way for a contractor to protect itself against LDs is to ensure that it manages its works diligently and effectively and that progress is closely monitored.

Conclusion

LDs are a universal feature of construction contracts. The FIDIC Guide notes that the purpose of LDs is to compensate the employer for losses it will suffer as a consequence of delayed completion. Where the amount of LDs is pre-agreed, the intention is that the employer does not have to prove actual loss and damage. Whether that is entirely correct may, as we discuss above, depend on the applicable law of the contract.

Unsurprisingly as we have seen, different jurisdictions deal with delay damages in different ways. And there is not a straight split between the civil codes and common law. For example, South Africa adopts a similar approach to the UAE. Under the Conventional Penalties Act 15 of 1962, the court can reduce the amount of LDs that might be applicable if the contractor can show that the employer will be unjustly enriched if he receives the LDs as specified in the contract, in other words if the employer is not suffering any loss due to the contractor’s delay.

The onus, of course, is on the contractor to show that the rate of LDs agreed is out of proportion to the loss suffered by the employer. In that there may be some similarity with the UK, where the onus is on the contractor to show that the rate of LDs is a penalty. However as Ahmed Ibrahim has said, whilst there may appear to be similarities, there are dangers in simply looking at LDs from the perspective of the law and legal approach you are familiar with.

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  • 1. Dubai Court of Cassation, 17 June 2001, case 302/21
  • 2. High Federal Court, case 25/24 – 1 June 2004 (Civil).
  • 3. Tremloc Ltd v. L Errill Properties Ltd (1987) 39 BLR 30
  • 4. However, the position has become slightly less clear following Coulson J’s judgment in Selby Hall and Philip Shivers v Jan Van Der Heiden 9 (No.2) [2010] EWHC 586 (TCC)
  • 5. (1915) AC 79
  • 6. For example, in Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] EWHC 281 (TCC)
  • 7. [2008] EWHC 1924 (QB)
  • 8. [2010] EWHC 2234 (Comm)