Liquidated damages: a note of caution

It is common for construction contracts to include a liquidated damages clause that quantifies and limits the compensation which will be payable for certain types of breach. However, owners and contractors operating in the Asia Pacific region are sometimes surprised to find that these clauses do not provide them with the certainty they intended and expected.

This newsletter highlights some key features of liquidated damages clauses. It then explores a number of issues that parties should bear in mind when planning to negotiate or enforce a liquidated damages clause in this region.

Liquidated Damages

A liquidated damages clause specifies an amount that will be payable as compensation in case of certain breaches of the contract. Liquidated damages are most often used as a remedy for delay and this newsletter will discuss them in that context. However, the same principles apply to liquidated damages clauses in other contexts, for example for failure to meet performance guarantees.

Most construction contracts require the contractor to complete the works within a specified time, either by a particular date or within a set period. These contracts commonly provide that if the contractor fails to complete within that time, a liquidated (that is, fixed and agreed) sum will be payable as damages for that breach of contract, up to the date when the works are finally completed. For example, clause 8.7 of the FIDIC Red Book (1999 edition) states:

If the Contractor fails to comply with Sub-Clause 8.2 [Time for Completion], the Contractor shall … 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.

These clauses have advantages for both parties. For owners, they eliminate the need to prove the actual amount of loss that has been suffered due to the delay, in circumstances where proving that loss may be extremely complex, time-consuming and expensive. In most cases, the owner can simply deduct or set-off the liquidated damages against payments otherwise owed to the contractor. For contractors, liquidated damages provide certainty as to the amount of their liability in case of delay, instead of open-ended and potentially huge claims. Where a contractor knows in advance both the agreed rate of liquidated damages and (often) the overall cap on liability, it is possible to assess and allow for the risk of late completion in the bid price.

English Law Principles

Many of the standard construction contracts used in the Asia Pacific region are derived from contract forms that were originally produced in England, and English law (or English-based laws, such as Singapore or Hong Kong law) is often selected as the governing law of the contract, particularly for larger projects and projects with international financing.

Freedom of contract is a fundamental principle of English law. Agreements that have been freely entered into should be enforced according to their agreed terms. However, there are some exceptions, including an exception that applies to so-called ‘penalty clauses’. These are clauses which impose a penalty for breach of the contract that is out of all proportion to the amount of damage that is likely to be caused by the breach. Given the scope for serious abuse of penalty provisions in situations of unequal bargaining power, these clauses are unenforceable under English law. For a liquidated damages provision to be valid under English law, the sum payable (i.e. the stated daily or weekly rate) must be a genuine pre-estimate of the damage likely to be caused by the delay, as assessed at the time the contract was made. Otherwise, the clause will be treated as an unenforceable penalty.

What is a “genuine” pre-estimate of future loss? The law is clear that it does not have to be an accurate estimate; the actual loss may subsequently turn out to be substantially higher or lower. The key question is whether the agreed rate of liquidated damages was a genuine (reasonable, commercially justificable) attempt to estimate the amount of loss that the employer might be likely to suffer as a result of the delay. It must not be unreasonably extravagant or simply arbitrary.

It should be mentioned that little, if any, reliance will be placed on express words in the contract which state that the clause is not considered to be a penalty.

Importantly, so long as the liquidated damages provision is found to be a genuine pre-estimate of loss, it is irrelevant whether there is in fact any loss. Therefore, an owner will be able to recover the contractual liquidated damages even if it actually suffers no loss, provided that the amount of liquidated damages appeared to be a genuine pre-estimate of likely losses at the time when the contract was made.

Unless there are words in the contract to the contrary, a liquidated damages clause will cover all damages for non-completion. It will therefore amount to an exhaustive remedy for losses caused by the delay: no additional compensation can be claimed. This can give rise to interesting consequences when parties enter “NIL” or similar wording against the relevant liquidated damages figure in the contract. In such a situation, the English court has held that the parties’ intention was not that the liquidated damages clause should be disregarded in favour of allowing a claim for actual damages, but that no damages should be payable at all for delayed completion!  

Liquidated Damages in Asia

Construction contracts in Asia frequently adopt wording for liquidated damages clauses that reflects the English law principles discussed above. It seems to be assumed without much enquiry that these clauses will work in much the same way no matter what law governs the contract. However, when liquidated damages clauses are assessed in light of the applicable local law, they may not have the effect that was intended.

Some of the more common regional examples are mentioned below.

Singapore, Hong Kong, Malaysia, Australia

The laws of Singapore, Hong Kong, Malaysia and states of Australia are all based closely on English common law. Therefore, if these laws govern a contract, the liquidated damages clause can usually be expected to operate effectively within the legal principles outlined above.

Even in these jurisdictions, however, there may be unexpected differences from the English position. For example, we have commented above on the English law view that where parties insert the word “NIL” into a standard-form liquidated damages provision, they may unintentionally exclude all damages for delay. In contrast, in a relatively recent case before the Western

Australian Court of Appeal (J-Corp Pty Ltd v Mladenis [2009] WASCA 157), the Court took the view that the circumstances of that case did not indicate that the parties had intended the words “NIL DOLLARS ($00.00)” to exclude any entitlement to damages.

Indonesia

There is a degree of uncertainty surrounding the status of liquidated damages clauses under Indonesian law. As a general principle, Indonesian law provides that the parties are free to determine the terms of the agreement between them (section 1338 of the Indonesian Civil Code). However, section 1339 of the Indonesian Civil Code also provides that the terms of that agreement may not violate “a sense of justice”. In conjunction with our associated Indonesian firm, Hiswara Bunjamin & Tandjung, we have succeeded in enforcing liquidated damages clauses before Indonesian Tribunals; on the other hand, we are also aware of situations where Indonesian Courts have lowered the level of liquidated damages stipulated in a contract on the basis that the original sums violated the “sense of justice”.

Difficult or unexpected issues can arise even where English law is selected as the governing law of an Indonesia-related contract. For example, BPMIGAS Decree 007 requires that procurement contracts for PSC’s must include a sanction for delay by way of “penalty” of at least 0.1 %of the contract price per day up to a total maximum of 5% of the contract price (or 20% for certain “high risk” contracts). There is a risk that this could be an unenforceable penalty under English law, if the required rates do not reflect a genuine pre-estimate of the damages actually likely to result in each particular case. Careful drafting is necessary in order to satisfy both the Indonesian regulations and the requirements of English law.

Thailand

There is debate amongst legal commentators as to whether Thai law will uphold a liquidated damages clause. Certain sections of the Thai Civil and Commercial Code suggest that the amount of liquidated damages stipulated in a Thai law contract may be increased or decreased by the Court in light of the actual amount of damage suffered by the party claiming the liquidated damages. For instance, section 380 paragraph 2 of the Civil and Commercial Code states:

“If the creditor 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.”

Conversely, section 383 of the Civil and Commercial Code states: ‘If a forfeited penalty is disproportionately high, it may be reduced to a reasonable amount by the Court’. Arguably, the combined effect of these sections is that liquidated damages clauses in Thai law contract may not operate effectively either as a limit or a floor on the contractor’s liability in case of delay.

Vietnam

Vietnam’s Commercial Law contemplates only two types of monetary remedies, namely penalties for breach (the limit of which is controlled under Vietnam law) and damages for loss (which cannot be determined in advance). On the other hand, however, Vietnam contract law in principle gives effect to the intent of the contracting parties and the Commercial Law permits parties to agree “other remedies provided that such remedies are not contrary to the fundamental principles of the laws of Vietnam”.

In light of these provisions, there are questions as to whether liquidated damages clauses are enforceable under Vietnam law. In particular, there is a risk that a Vietnam Court would consider it a “fundamental principle of the laws of Vietnam” that only two types of monetary remedies are permitted, and so would not enforce a liquidated damages clause.

Comment

A liquidated damages clause can give certainty to owners and contractors alike. It can also simplify the process of payment certification and contract administration. However, it is important to be aware that a “one size fits all” approach to such clauses will not work in this region.

Not only should the parties ensure that their agreement is clearly and unequivocally expressed, but they should also consider whether they need to tailor the liquidated damages clause to the requirements of the particular jurisdiction concerned. In particular, it is important to obtain advice as to whether the clause will be enforceable under the governing law of the contract. Failure to do so may mean that the clause cannot be enforced and could hamper efforts to recover damages altogether.