This is the latest in our monthly series of e-briefings about clauses in commercial contracts which often give rise to disputes between the parties. We look here at some of the issues associated with clauses imposing liability to pay liquidated damages.
What are liquidated damages?
Liquidated damages (or "LDs") clauses are widely used in commercial contracts, particularly in construction and engineering contracts but in other contexts too. In summary, they provide that if one party breaches the contract (for example by failing to complete work on time or by delivering a defective product), that party must pay the other party a pre-determined daily or weekly sum until the breach has been remedied (for example, until the work is complete or the defect has been rectified). Importantly, the clause may provide that these LDs are the only liability of that party in respect of that breach, i.e. that there will be no further liability to pay additional general damages for breach of contract.
Thus an LDs clause might state (in simplified form): "If the Contractor fails to complete the Works by the Completion Date, the Contractor's only liability to the Employer for such failure shall be to pay $[X] for each day until the works are complete". The rate of payment is specified in the contract and is usually subject to an upper limit such as a percentage of (or all of) the contract price.
It is sometimes not understood that this clause has benefits for both parties. The "innocent" party gains an immediate contractual right to compensation; it does not have the burden of proving what loss it actually suffered by the breach. On the other hand, the party in breach has the reassurance of knowing that its liability is capped at the agreed amount of LDs; it does not face the risk of unlimited exposure for major breach. LDs clauses therefore provide a clear and certain allocation of financial risk by imposing both a maximum liability and a minimum entitlement for a breach of contract.
Legal status of LDs clauses in Thailand
LDs clauses are increasingly common in Thai contracts. However, contracting parties should be aware that arguments regularly emerge in Thailand about the legal status of these clauses. Their effect under Thai law is less certain than might be supposed. In fact it is not certain whether Thai law will uphold either the maximum liability or the minimum entitlement aspects of these clauses.
The uncertainty stems from the fact that there are no detailed rules of Thai law to confirm the validity and effect of LDs clauses. In the absence of specific rules it is therefore necessary to apply the nearest comparable principles, which are those in the Civil and Commercial Code that deal with contractual "penalties". These rules apply where a defaulting party is bound by a contract to make a "payment of a sum of money as penalty in case he does not perform his obligation or does not perform it in the proper manner" (see section 379 of the CCC). These rules – discussed below – do not fit entirely comfortably with the principles underlying LDs clauses.
LDs as a minimum entitlement
Section 383 of the CCC provides that: "If a forfeited penalty is disproportionately high, it may be reduced to a reasonable amount by the court."
This suggests that agreed LDs may be reduced if a court (or arbitrator) considers them disproportionately high compared to the amount of damage actually suffered. If that interpretation is right, the parties and the court may be obliged to undertake a full assessment of actual loss caused by a contract breach in order to decide if LDs are proportionate – exactly the assessment that LDs clauses are designed to avoid. It suggests too that in some cases the court can reduce the LDs payable notwithstanding the clear terms of the parties' agreement.
LDs as a maximum liability
The possibility for court reduction of LDs is not unique to Thai law. Other legal systems invalidate LDs clauses that do not appear to reflect the parties' genuine pre-estimate of the losses likely to flow from the breach. Less commonly, however, Thai law also calls into question the role of LDs clauses as caps on potential liability. Section 380 of the CCC states:
"If the [injured party] has a claim for compensation for non-performance, he may demand the forfeited penalty as the minimum amount of the damage. Proof of further damage is admissible."
This suggests that financial liability for breach of contract may not be limited to the agreed amount of LDs. Rather, the injured party may claim LDs under the contract and then also claim additional damages to the extent that it can prove greater loss. This could prove a nasty shock for a party who had assumed that its liability under a contract was safely capped.
There is a counter-argument. Under Thai law, parties are free to agree whatever they wish in a commercial contract, unless the agreement is prohibited by a specific law or is contrary to public order or good morals. LDs clauses would hardly appear to be contrary to public order or good morals, and they are not specifically prohibited (nor indeed referred to at all) in any section of the CCC or other code or statute. It can therefore be argued that an LDs clause should be applied exactly as the parties intended, in accordance with the principle of freedom of contract, particularly where the clause has been agreed between sophisticated commercial partners who should be assumed to understand the implications. In other words, it may be argued that the rules on contractual penalties should apply.
Whatever the legal complexities described above, there are still good reasons to include LDs clauses in Thai contracts. Thai courts and arbitrators may decide to uphold and apply these clauses as they are drafted, and even if an LDs clause is ultimately held to be unenforceable, it will in the interim provide a clear basis for deducting a pre-determined and certain sum from ongoing contract payments in case of delay or other default. This may simplify the process of contract administration.
Nevertheless, as a practical matter an LDs clause should be drafted as clearly as possible to minimise doubt about the intention of the parties and to reduce the scope for unwanted disputes. For example:
An LDs clause should ideally state that the parties have freely accepted it and intend to be bound by it, and that the clause is intended to apply both as a minimum entitlement and as a maximum liability for damages, whatever the actual amount of loss that may be suffered.
- It may help to add words that often appear in LDs clauses in other legal systems, to the effect that the amount payable is not a penalty but instead represents the parties' genuine pre-estimate of losses which might flow from the breach, and their agreed commercial arrangement regarding compensation for those losses.
- It might also help to provide for disputes under the contract to be resolved by arbitration rather than in Thai courts. It is sometimes said that arbitrators are more likely to uphold and apply LDs clauses than judges who, perhaps, lack the same industry experience and understanding.
None of these suggestions is guaranteed to avoid the arguments discussed earlier. But cumulatively they should at least reduce the likelihood of a court or arbitrator refusing to uphold the careful economic calibration and risk allocation that an LDs clause represents.