Jordan ... be realistic in your expectations.
Liquidated damages: are they worth it
01 April 2015
STUART JORDAN* briefly discusses liquidated damages and their consequences in construction contracts.
Liquidated damages, one of the defining characteristics of construction contracts, are used in every sort of contract in the Middle East. All of the major international published standard forms of contract make use of them.
You would think from this that liquidated damages are indispensable. In reality, are they of such value and do we really think about what we are doing when we use them? In particular, do we think about enforceability of these provisions in the UAE and elsewhere? Are there alternative approaches?
As we all know, liquidated damages are simply pre-agreed sums to be paid in the event of specified breaches of contract. They are most useful where the consequences of the breach are easily measured – so delay in completion of works is the most common use. In EPCs (engineering, procurement and construction), liquidated damages usually become payable for underperformance of plant on performance testing.
The understood benefits of liquidated damages are simplicity, predictability and convenience. Everyone knows the consequences of the breach; the owner does not have to go through the expense and trouble of proving a particular sum for compensation. Liquidated damages are, therefore, immediate and can be demanded or withheld from contract payments immediately.
Are there any disadvantages? This question is not often asked. There are consequences to using liquidated damages:
First, the liquidated damages are generally understood to stand in the place of economic and “indirect or consequential losses” (so called) arising from delayed completion or underperforming plant. In any commercial project, these of course are the main losses: delayed or reduced revenue, additional finance costs, default in third-party contracts, etc. Nevertheless, parties often agree to exclude such losses and rely on liquidated damages. Whether they actually achieve that exclusion is another matter.
Second, liquidated damages are usually taken to be the exclusive remedy for the specified breach (regardless of whatever the parties have agreed to exclude). This is the settled position in English law and it is the logical position generally, that the owner cannot claim any additional damages for (say) delayed completion, no matter what the reason, however long it lasts (so long as the works are completed without contract termination intervening) and no matter what unexpected losses arise.
Third, parties are more often agreeing on contractor liability caps, including sub-caps for liability under liquidated damages. Very substantial losses can be unrecoverable.
Of course, all of these issues can be dealt with by careful calibration of the liquidated damages provisions. The reality is, however, that the parties hardly ever agree on sums which come anywhere near actual losses. The tacit agreement is that much lower figures are agreed in exchange for the immediacy of having to pay them. Also, attempts to set up varying rates of damages for different periods or to trigger on particular owner losses, tend to defeat the objective of simplicity.
The conventional thinking is that, whatever the drawbacks, liquidated damages are still worth it because of their simplicity, predictability and convenience. So, are those advantages really so clear? In truth, they are probably only clear in England where the law most vigorously keeps the parties to their bargain. In the UAE, there is much more room for courts or arbitrators to depart from the terms agreed and to look at the outcome. Even in the US, another common law country, there is the established legal principle of “no harm, no foul”, which also directs courts or arbitrators towards a review of the actual consequences of the breach, as opposed to simply upholding the agreed liquidated damages as calculated.
In the UAE, there is a range of provisions that detract from the certainty of relying on liquidated damages. Of course, Article 258 of the UAE Civil Code provides in favour of the upholding of agreements, stating that they will be read and construed with their true meaning. This, however, is counterbalanced with strong legal principles in favour of sharing the benefit of an agreement, fairness of outcomes and disallowing unjust enrichment.
These principles are expressed many times over in the Civil Code, including provisions allowing a judge to intervene to make compensation equal to the loss (Article 309) and to adjust and pre-agreed limit (390) and against exercis```e of a right if the interests asserted are disproportionate to the harm suffered by the other party (106). There are other parts of the code specifically dealing with unjust enrichment.
All of that is a pretty clear signal that liquidated damages will be subject to scrutiny should there be a dispute about paying them. Regardless of the outcome of that scrutiny, the main advantages are already lost: the owner must go through the process of showing actual losses.
Some obvious questions also arise: What if actual losses don’t reach the liquidated damages? Are actual losses simply substituted for the agreed sums? Some commentators take the view that a court will try to give some effect to the agreed damages rather than ignore them completely. At best, this might be judged as a matter of degree (discrepancy between the two sums) and is, therefore, uncertain.
What if actual losses are above the agreed sums? On the above principles, a court can award more than the liquidated damages, although again it cannot be taken as certain.
There are good practical reasons for our industry’s continuing use of liquidated damages. Not least is that it usually doesn’t end up in a fight. They are often just paid. Neither party wants to know the real losses! We should at least be realistic in our expectations, and remember that there are alternative ways to provide for compensation for delay and underperformance.
*Stuart Jordan is partner and co-head construction for the international law firm King & Wood Mallesons (KWM). Based largely in Dubai, UAE, he specialises in engineering and construction matters, cross border, both front end and disputes.
