Liquidated damages: the differing approaches in the UAE and the UK

By Jeremy Glover, Partner, Fenwick Elliott

Liquidated damages tend to be a fairly standard part of most construction and engineering projects. Subject to express agreement, there is normally to be implied into a building contract a term that the contractor will complete the works within a reasonable time. If, without sufficient excuse, the contractor is late in completing the works then under the common law principles he is liable to pay damages at common law.  Formal building contracts not only usually quantify precisely the completion date, but also fix the amount recoverable by an employer for delay in completion of the works by a liquidated damages clause.

The FIDIC Form of Contract

By way of example, sub-clause 8.7 of the FIDIC Yellow Book says this:

“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.”

The FIDIC Guide notes that the purpose of delay damages is to compensate the Employer for losses he will suffer as a consequence of delayed completion. Where the amount of delay damages is pre-agreed, the intention is that the Employer does not have to prove actual loss and damage. Whether that is entirely correct may depend on the applicable law.

The position in the UAE

For example, in the UAE, Article 390 of the Civil Transactions law (Civil Code) 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.”

Therefore in the UAE, a contractor may challenge the element of “loss”. Article 390(2) entitles the judge to vary the parties’ agreement to reflect the actual loss. For example, the UAE High Federal Court in Abu Dhabi1 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. In addition, the element of loss which is suffered by the other party should be established’. If the contractor succeeds in establishing the absence of loss, the agreed compensation should be repudiated.”2

In other words, a court may set aside entirely the liquidated damage, in the unlikely event of the employer suffering no loss from the delay. Further, the court may also award less damages reflecting the actual loss. In both scenarios, the burden of proof is placed squarely on the contractor. Similar standards will be applied to the employer who is trying to argue that his actual loss exceeds the liquidated damages. However, parties should be aware that as a starting point, the court will attempt to respect the parties’ agreement and so in practice is reluctant to vary the liquidated damages clause unless it is evident that the liquidated damages considerably exceed the actual loss. 

The traditional position in England and Wales

Under English law, the traditional starting point has always been that a liquidated damages clause will not be enforceable where it constitutes a “penalty”.  In England and other common law jurisdictions, the approach is based on the House of Lords’ decision just over 100 years ago in Dunlop v Matthew Tyre Co Ltd v New Garage Motor Co Ltd.2

The approach that the courts followed was set out by Mr Justice Jackson in his review of the position in Alfred McAlpine Capital Projects Ltd v Tilebox.3 He made four general observations:

“1. There seem to be two strands in the authorities. In some cases judges consider whether there is an unconscionable or extravagant disproportion between the damages stipulated in the contract and the true amount of damages likely to be suffered. In other cases the courts consider whether the level of damages stipulated was reasonable. Mr Darling submits, and I accept, that these two strands can be reconciled. In my view, a pre-estimate of damages 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.

2.  Although many authorities use or echo the phrase ‘genuine pre-estimate’, the test does not turn upon the genuineness or honesty of the party or parties who made the pre-estimate. The test is primarily an objective one, even though the court has some regard to the thought processes of the parties at the time of contracting.

3.  Because the rule about penalties is an anomaly within the law of contract, the courts are predisposed, where possible, to uphold contractual terms which fix the level of damages for breach. This predisposition is even stronger in the case of commercial contracts freely entered into between parties of comparable bargaining power.

4.  Looking at the bundle of authorities provided in this case, I note only four cases where the relevant clause has been struck down as a penalty. These are Commissioner of Public Works v Hills [1906] A.C. 368, Bridge v Campbell Discount Co Ltd [1962] A.C. 600, Workers Trust and Merchant Bank Limited v Dojap Investments Limited [1993] A.C. 573, and Ariston SRL v Charly Records (Court of Appeal, March 13, 1990). In each of these four cases there was, in fact, a very wide gulf between (a) the level of damages likely to be suffered, and (b) the level of damages stipulated in the contract.”

Mr Justice Jackson’s judgment provides a reminder that, as in the UAE, cases where liquidated damages were overturned are rare. However, in summary, the predetermined level of liquidated damages had to represent a genuine pre-estimate of the employer’s likely loss should the specified breach occur. There was no requirement for the employer to prove that it had actually suffered the loss provided for by the liquidated damages provision, and the employer would still be entitled to the amount of liquidated damages stipulated by the contract even if its actual loss was lower.

The new test in England and Wales

In England and Wales at least, that position and traditional test have now changed following the decision handed down on 4 November 2015, of a seven-strong bench of the Supreme Court in the case of Cavendish Square Holdings BV (Appellant) v Tatal El Makdessi (Respondent).4 The Supreme Court held that the correct approach in commercial cases was to have regard to the nature and extent of the innocent party’s (e.g. the employer’s) interest in the performance of the obligation that was breached as a matter of construction of the contract. In doing so, the Supreme Court formulated a new test, namely whether or not the clause which provides for liquidated damages:

“imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin’s four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.”

The basic principle that a penalty is unenforceable remains unchanged. The real question when a contractual provision is challenged as a penalty is whether it is penal and not any longer whether it is a genuine pre-estimate of loss. The fact that a clause is not a genuine pre-estimate of loss does not necessarily mean that it is penal. What this means is that a penalty clause whose purpose is to punish the contract-breaker is likely to be an unenforceable penalty clause, whereas a clause that is intended to deter a breach of contract is less likely to be a penalty clause, even if it does not represent a genuine pre-estimate of loss. It is important to remember both that the principle behind the new rule is intended to deter a breach of contract and also that this means that the rate of liquidated damages does not necessarily have to be representative of any actual financial loss the employer may have suffered.

Can the liquidated damages clause be commercially justified? For example, this might mean that commercial interests such as reputational issues, goodwill, the interests of third parties and other losses that cannot be easily quantified can now be taken into account in determining the level of liquidated damages. Further, if a liquidated damages clause has been negotiated in a commercial contract made between two parties of comparable bargaining power then there will be a strong initial presumption that the clause is not out of all proportion to the employer’s legitimate interests in timely completion. In other words, this new test requires a consideration of the commercial justification for the liquidated damages clause at the time the contract was entered into, and whether it is out of all proportion to the employer’s legitimate commercial interest in the works completing on time.

One thing that remains unchanged is the recommendation that it is always sensible to keep a record and explanation of the reasons (perhaps including details of any negotiations) why the amount of the liquidated damages was set at the level it was, and why it represents a reasonable and proportionate protection of a legitimate commercial interest.

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• 1. High Federal Court, case 25/24 – 1 June 2004 (Civil)
• 2. [1915] AC 79
• 3. [2005] EWHC 281
• 4. [2015] UKSC 67. For further details about the Supreme Court’s decision see Insight No.53 dated November 2015.