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Liquidated Damages and Penalties inthe Middle East Liquidated damages are widely used and recognised inconstruction contracts in the Middle East but it is unwise to relyon preconceptions based on familiar common law principleswhen considering the effect and impact of local laws. MaxWieliczko considers the pitfalls and highlights thedifferences arising from local legal principles. Introduction Whilst some familiar legal concepts are reflected in Middle Eastern legal jurisdictions,there are some important differences. It is unwise for parties to assume that familiarcontracts will be enforced with the same outcome under local law. The approach to pre-agreement of compensation for breach of contract is an area where local law maysurprise the unwary. Law in the Middle East Legal systems in the Middle East have a degree of commonality as they are founded onIslamic Sharia law and similar civil law principles; for example the UAE, Qatar, Kuwait,Jordan, Libya and Syria have adopted codes based on the Egyptian Civil Code.The influence of Sharia law distinguishes Middle Eastern civil codes from Western civilcodes. Sharia is a Divine source of inspiration, embracing both ethical standards andlegal rules, aimed at achieving fairness, justice and a proper balance of benefits betweenparties. What are liquidated damages? Liquidated damages are a common law concept, whereby a fixed sum is pre-agreed ascompensation for a specified performance default; most commonly delay, but sometimesperformance shortfall, loss of availability etc. Most construction contracts require theContractor to complete work within a fixed timeframe, with liquidated damages specifiedas a sum payable for each day or week of delay to completion. Liquidated damages are a permitted exception to the common law principle thatrecoverable loss is restricted to the actual loss suffered by the innocent party as aconsequence of the breach of contract. Provided the agreed liquidated damages reflecta genuine pre-estimate of the loss which the Employer might suffer as a consequence ofthe breach, they are normally fully recoverable; even if the Employer suffers no actualloss. Advantages of liquidated damages Pre-agreeing the consequences of breach affords both parties certainty as to their liabilityin the event of default. In common law jurisdictions liquidated damages give theContractor the comfort of a maximum cap on its liability for certain defaults, which helpsthe Contractor to determine its risk when fixing the Contract Price. The Employer alsobenefits from this pre-agreement, as it does not have to prove actual loss or causation,and will not fall foul of common law rules prohibiting recovery of losses considered tooremote. Is it a penalty? The Common Law perspective The principal defining feature of liquidated damages is that they must be intended to becompensatory in nature; so that, at the time they are agreed, they must not exceed theEmployer’s realistically conceivable losses for the contemplated breach. Common lawsystems demonstrate an antipathy toward penalties, which are deemed unenforceable,and therefore to the extent that a liquidated damages provision is shown to be a penalty itmay be held unenforceable.The essence of a penalty is that it does not relate to actual loss likely to be suffered bythe innocent party, but is merely a pre-agreed amount fixed in the contract, intended toinduce performance by punishing default.Nevertheless, where liquidated damages provisions have been freely negotiated bycommercial parties, common law courts have demonstrated a marked unwillingness tointerfere with the parties’ intentions, and there is a presumption that a pre-agreed sumfixed as liquidated damages will be recoverable. When such provisions fail, they tend todo so for mechanistic reasons, rather than because the amount fixed is, in absoluteterms, penal. The burden of proof is on the Contractor to prove that the pre-agreed sumis a penalty. The adjustment of pre-agreed compensation – the Middle Eastern perspective Pre-agreed liquidated damages will in principle be enforceable in the Middle East, evenwhen expressly labelled as a “penalty”. This is because, whilst Middle Eastern lawsrecognise and permit the pre-agreement of the financial consequences of breach, theymake no conceptual distinction between “penalties” and “liquidated damages”.Liquidated damages under common law cannot be unilaterally adjusted after they havebeen agreed, nor can they usually be adjusted by the Court to better reflect the lossactually suffered by the innocent party. By contrast, and alarmingly for the unwary,Middle Eastern systems do allow for adjustment of pre-agreed compensation, becausethis reflects the Sharia principle of achieving fairness. The Qatari Civil Code, for example, provides that the Court has a discretion to make noaward of liquidated damages if the Contractor can prove that the Employer has notsuffered any actual loss. The Court also has discretion to reduce the pre-agreed amountif it considers that it is grossly excessive, or if the srcinal obligation to which the pre-agreed sum related has been partially fulfilled. Parties cannot contract out of thesemandatory provisions. Furthermore, the Qatari Court can also in limited circumstancesaward damages above the pre-agreed level if the Employer is able to prove that theContractor has committed fraud or some gross error/negligence. These reflect equivalentprovisions under the Egyptian Civil Code.Similarly, the Court in the UAE may adjust a sum pre-agreed by the parties. The UAECivil Code provides that the Court may, on the application of either party, adjust the pre-agreed amount so that it is equal to the actual loss. Again, parties cannot contract out ofthese provisions. Unlike the Egyptian and Qatari Civil Codes, there are no specifiedcircumstances in which the Court will upwardly adjust a pre-agreed amount. However itis unlikely that it would be done unless the discrepancy between the predeterminedamount and the actual loss is substantial. On the face of it, it would appear to betheoretically easier in the UAE, than in Qatar, or Egypt, to persuade a Court to make anupward adjustment, and no extreme default need be established as a precondition toupwardly adjusting a pre-agreed amount. Implications and conclusions The Middle Eastern system could work, in different circumstances, to the advantage ordisadvantage of the Employer or Contractor. An Employer may wish to fix high liquidateddamages to ensure the Contractor completes on time, but the Contractor may take somecomfort in knowing that, in certain circumstances, the Courts may hold these to beunenforceable or reduce them. Where a Contractor is faced with paying liquidateddamages that exceed the Employer’s actual loss, it is clearly beneficial to the Contractorto have an opportunity to reduce the liquidated damages. An Employer on the other handmay be able to obtain excess damages beyond the agreed sum, closer to its actuallosses, but the ease of doing so will depend on the particular jurisdiction.The ability to adjust the pre-agreed compensation takes away the certainty usuallyafforded in common law jurisdictions by a liquidated damages provision, and actual lossmay have to be ascertained in accordance with local legal rules. However, suchprovisions still reverse the burden of proof from a position where no sum has been pre-agreed, and set a presumption for recovery of the agreed sum which has to be overcomeif the amount is to be adjusted.Given these uncertainties it is clearly dangerous to assume that familiar contractuallanguage and formats will give rise to the same predictable common law outcomes thatwe are used to, and a proper understanding of local law is key when negotiatingcontracts in the Middle East. Key Points: ã Liquidated damages are a fixed amount pre-agreed in the contract as compensationfor a specified performance default. ã Middle Eastern jurisdictions do not make a conceptual distinction between “liquidateddamages” and “penalties”, which is alarming to those familiar with common law,where “penalties” are normally unenforceable. ã The key difference between common law and Middle Eastern civil codes is that theamount of pre-agreed damages can be adjusted by the Courts if the Employer’sactual losses are more or less than the amount in the Contract. ã In the Middle East liquidated damages provisions cannot be relied upon either as acap on the Contractor’s liability, or as a certain amount recoverable by the Employer. Max Wieliczko
[email protected] 0207 651 4639Maxwell Winward LLP, 100 Ludgate Hill, London, EC4M 7REwww.maxwellwinward.com
