In January of 2012, Macy’s, a renowned retail store, decided to sue Martha Stewart for entering into a contract with a rival retail store J.C. Penney, which they claimed breached their own contract with Martha Stewart for exclusive products in 2006. This led to a bitter war against J.C. Penney and Martha Stewart, leading to a settlement in 2014, and a revival of Macy’s claims against J.C. Penney in 2015.
This is an example of contracts gone sour. In a typical legal scenario, such as the aforementioned example, when a contract is drafted, an essential point of consideration for parties is the eventuality of a breach of contract and a remedy thereof. In layman’s terms, determination of monetary sum to be paid by the defaulting party committing breach to the aggrieved party sustaining a loss because of such a breach. The amount of compensation so determined for the breach is termed as liquidated damages.
Liquidated damages and its implications under different legal systems
The claim amount as to liquidated damages is determined at the time of preparation of a contract to compensate towards any delay in delivery or completion of a particular service, or where a service fails to meet a certain specified target. It is, however, imperative to understand that the payment of liquidated damages shall be triggered only upon breach of the stipulated contractual obligation upon a party under the contract and the aggrieved party has consequently sustained losses thereof. The main purpose of awarding liquidated damages to an aggrieved party is to make good the losses and restore such party to its economic position it would have been in, had it not been negatively affected by a breach of contract. Consider the situation where a contract provides for payment of liquidated damages by party A to party B in the event the contractual obligation by party A to complete the work assigned to it under the contract within the stipulated timeline is not met. Therefore, party A will be liable to make payment of the pre-estimated liquidated damages provided for in the contract only upon its breach of obligation whereupon party B has sustained an actual loss.
Now, there are numerous cases where the actual loss sustained by the aggrieved party will be less than the amount of compensation provided as liquidated damages under the contract. This disparity in amount will not in itself invalidate the contractual provision since the parties cannot be expected to be able to envisage every such scenario and estimate the losses for each. However, at the same time, if, the stipulated compensation as liquidated damages is significantly higher than the amount required to compensate the aggrieved party for its loss, this stipulation may be construed to be a deterrent of breach of performance, added to compel performance of the contract rather than making good the losses incurred on account of such breach. This stipulation may be characterized by the courts as provision for a penalty.
The problem often faced by parties while finalizing terms of a contract is determining the losses likely to cause in the event of a breach and therefore end up negotiating a ballpark figure commercially viable and acceptable to both parties, which may be higher than the actual loss suffered at the time of the breach. Therefore, in such scenarios, it may be difficult for the courts to distinguish between a penalty and a genuine pre-estimate of loss.
This article discusses the varied treatment of liquidated damages vis-à-vis penalty amongst different jurisdictions.
Legal framework under the English Law
Under English law, the traditional starting point has always been that a liquidated damages clause will not be enforceable where it constitutes a penalty. English law does not recognize penalty clauses i.e. provisions which are (as objectively interpreted) penal in nature, in the sense that the detriment (such as liquidated damages) imposed by the relevant provisions is disproportionately excessive in comparison with the legitimate interest of the innocent party (such as its monetary loss and, where applicable, any wider legitimate interest) in enforcing those provisions. The aforesaid rule has been set in stone on the basis of the key decision of the House of Lords’ in Dunlop Pneumatic Tyre Co. Ltd. v New Garage & Motor Co. Ltd [i]. which stated that in order for a liquidated damages clause to be enforceable, rather than being a penalty, the amount of compensation payable upon breach must be a genuine pre-estimate of the loss the innocent party would suffer in respect of that breach. If the intention of the liquidated damages clause is to threaten the guilty party into performance rather than to compensate the innocent party, it will likely be seen as a penalty. This means that the clause will be enforceable if the sum was considered by the parties at the time of entering into the contract to be a genuine pre-estimate of the loss that might be incurred as a result of the breach in question. The principle ruled in Dunlop Pneumatic Tyre matter has been relied upon in a number of cases since its decision a century ago.
Another important question was considered in the case of Alfred McAlpine Capital Projects Ltd v Tilebox Ltd[ii], where it was held that as long as the amount of compensation is not extravagant; it does not mean that it has to be very similar in amount to the actual losses. Further, the point in time for the assessment of whether a stipulated figure is a genuine pre-estimate or a penalty is when the contract is entered into, not when the delay occurs.
In consideration of the above, in situations where a party faces a high amount of liquidated damages imposed upon it under a contract on a delay in completion of a project, it is likely that Such party may challenge the liquidated damages on the ground that the claim amount of liquidated damages constitutes a penalty rather than a genuine pre-estimate of loss and therefore is unenforceable. However, the court in such situations would require the party making such allegations to establish that the essential reason for the inclusion of such penalty clause was to deter the party from breaking the contract, rather than to compensate the innocent party for the breach. The proportionality of the damages to the losses anticipated to be incurred is a vital element in maintaining a valid liquidated damages claim.
It is imperative to note that the traditional position ascribed by Dunlop Pneumatic Tyre Co. Ltd has now changed in terms of the widely publicized UK Supreme Court judgment of Cavendish Square Holdings BV vTatal El Makdessi. [iii] 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 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 aggrieved party may have suffered.
Legal framework under the UAE Laws
The principle of liquidated damages under the UAE legal framework is provided under article 390 of the Civil Transactions law [iv] (the Civil Code), which states that:
“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.”
For the purpose of interpreting the liquidated damages in terms of the aforesaid provision of the Civil Code, the UAE Court held that “delay fine 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.”[v]
The UAE high courts have taken a similar view in a number of cases which in essence mean that the court has the power to set aside entirely the liquidated damage, in the event of the party suffers no loss from the breach for which liquidated damages were provided. Further, the court may also revise the amount of liquidated damage in order to mirror the actual loss. In both scenarios, the burden of proof is placed squarely on the defaulting party. Similarly, where the employer contends that his actual loss suffered exceeds the liquidated damages, the burden of proof shall be on him to prove the claim. However, in reality, the court may consider the parties’ agreement and may be reluctant to vary the liquidated damages clause unless it is evident that the liquidated damages considerably differ from the actual loss.
Another important aspect that differentiates the UAE Law from the English Law is that the Arabic term used, mostly by state courts, for ‘liquidated damages’ can be translated to mean ‘delay fines’ or ‘penalty clause’. This highlights that the nomenclature of the clause is not a matter of determination before the courts for establishing the veracity of liquidated damages; which has so far been the situation under the common law jurisdictions where the penal nature of liquidated damages has been a ground to refuse their enforceability. Having said that, the term liquidated damages is also commonly used in the United Arab Emirates, given the widespread use of English language in the UAE.
Furthermore, under the Civil Code, liquidated damages is a pre-agreed assessment of the loss, thus, it concerns the quantification of damages as opposed to the liability for damages. The liability for damages shall be triggered upon the breach of the primary obligation under the contract. Hence, the aggrieved party’s obligation to pay liquidated damages is an ancillary obligation, which will arise when the party defaults in its primary obligation.
Consequently, if a construction contract is terminated, the liquidated damages clause automatically becomes valueless; however, the defaulting party may still be vulnerable towards a claim for unliquidated (general) damages.
The aforesaid principle is established by the Dubai Court of Cassation, “delay fines contained in contracts are deemed to be a penalty clause which is a secondary obligation correlated to the primary obligation, and it is a forfeit to the breach of the latter. The ineffectiveness of the primary obligation – as a result of the contract termination – leads to the ineffectiveness of the penalty clause. It follows that the court should not take account of the agreed damages stated in the delay fines clause; the judge may award general damages subject to proof of fault and loss according to the general rules.”[vi]
In view of the above, under the UAE legal framework, despite what the parties may have agreed to the contract, the court or even an arbitrator, as the case may be, is entitled to pass an order changing the terms of the contract to ensure that the damages are in fact equal to the loss that has been suffered by the aggrieved parties.
Legal framework under the Indian Law
Although the Indian law is modeled on the English Law and earlier differentiating the penalty and liquidated damages was also based on English Law, the introduction of the word penalty to the provision of liquidated damages within the Indian Contract Act, 1872 (the Indian Contract Act) by way of an amendment in the year 1899 has revised the interpretation of liquidated damages under the Indian Contract Act.
Sections 73 and 74 of the Indian Contract Act deal with the provision of liquidated damages. Section 73 states “when a contract has been broken, the aggrieved party is entitled to get compensation or any loss or damages which have been inflicted on him/her naturally during the usual course of breach of contract or about which the parties to the contract has prior knowledge when they entered the contract”.
Further, section 74 further states “when a contract has been broken, and if a sum is named in the contract as the amount to be paid for such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.” A bare perusal of the aforementioned provision evidences that the Indian Law does not distinguish between liquidated damages and penalty. As discussed hereinabove, before the amendment of 1899, all Indian cases followed the common law perspective, but the amendment broadened the purview of section 74 of the Indian Contract Act.
Hence, in view of the provisions of the Indian Contract Act and the interpretation of the courts, it is understood that liquidated damages under the Indian legal system are based on the genuine pre-estimate of the loss, whereas a penalty is based on the doctrine of reasonable compensation. Section 73 also lays down the principles for damages pertaining to the difference between the cost and price of the goods and services at the time of the contract and the time when the contract was breached. It is therefore upon the courts in India to determine on the basis of the facts before it, whether the case involves liquidated damages or penalty. Also, since under the Indian Law, there is no difference in relation to liquidated damages and penalty, penalty provisions can also be upheld or imposed in certain situations like delay in completion of the work or delay in supply of goods.
In today’s economic world where cross-border transactions and multi-jurisdiction contracts are a norm, it is essential to understand the interpretation of legal provisions under the relevant jurisdictions which may affect a contract. On an overall assessment of laws under different jurisdictions, it can be seen that liquidated damages provisions can be a powerful toolto help you assert rights and bring a greater degree of certainty under a contract. The parties, however, have to be careful not to be too aggressive when determining the amount of the damages, as the courts will not enforce such excessive clauses. It is therefore much more important for parties to a contract to have a clear understanding of how the penalty rule works and how to word the relevant clause so as to mitigate the adverse consequences that might arise from accepting the proposed amount of liquidated damages. As a result, in order to avoid any complications, any prudent person seeking to include a liquidated damages provision in a contract may want to keep an explanation of the amount of the liquidated damages and why it represents a reasonable and proportionate protection of a legitimate commercial interest.