By KATIE LISZKA

THE use of liquidated damages provisions is widespread throughout the construction industry. Those operating in the industry locally are generally familiar with the underlying legal principles applying to such provisions, such as the fact that there are marked differences between the treatment of liquidated damages under the UAE law and English law.

 Project finance is a relatively new model in the region and the use of liquidated damages provisions can throw up some interesting considerations when used in the project finance arena.

It is commonplace for construction contracts to provide for liquidated damages that become payable in the event of a failure to complete the works before the contractual date for completion. These damages are fixed and the quantum is agreed by the parties in advance. A typical clause requires the contractor to pay or allow the employer to deduct liquidated damages at a rate per day or week for delay in the completion of the building project. Liquidated damages may also be used for other types of breach, such as a failure to reach a certain level of performance, but this article is only concerned with liquidated damages in respect of delay.

Under English law

Under English law, liquidated damages should represent a genuine pre-estimate of loss, made at the time of entering into the contract.

If the contractor can demonstrate that the rate of liquidated damages is far in excess of the greatest loss that could conceivably result from the default, it may be held to be a penalty and, therefore, unenforceable. In such a case, an employer’s remedy is to rely on its common law right to damages for breach of contract. It is good practice for the employer to keep a record of how it has calculated the potential loss on which the liquidated damages are based, in case this is challenged.

The English law approach to liquidated damages brings about numerous benefits from the perspectives of both the employer and the contractor. For the contractor, the benefit in clearly expressing a liquidated amount provides certainty about its level of exposure in the event of certain defaults. On the other hand, for the employer, the main benefit is that it does not need to establish that the breach committed by the contractor resulted in a loss. The commercial benefit to be gained in upholding such clauses and thereby providing for certainty of contract is not to be underestimated.

Under UAE law

Liquidated damages operate somewhat differently under UAE law. Article 390(1) of the Civil Code provides that the contracting parties are able to agree on a fixed amount of compensation in advance. Article 390(2) gives the court the power, upon the request of one of the parties, to increase or decrease the amount of the compensation so that it mirrors the actual loss suffered by the employer. Article 390(2) of the Civil Code can be used by either the employer, aiming for the liquidated damages figure that was initially agreed in the contract to be increased, or by the contractor, who will be seeking the opposite.

There are cases to show that the courts in the UAE are prepared to exercise their discretion to modify the sum of liquidated damages to reflect the actual damage suffered by the employer. In case number 138/94, before the Dubai Court of Cassation, for example, the court elected to modify the pre-agreed damages and further demonstrated that the concept of a penalty, as opposed to a genuine pre-estimate of loss, was irrelevant in its considerations.

The approach is different from that of the English courts, where the courts by and large enforce the terms of the contract which the contracting parties have negotiated and are disinclined to interfere with the parties’ intentions. In the UAE, courts can, and have shown that they will, retrospectively change the parties’ express agreement.

In project finance

Now consider how liquidated damages provisions operate in a project finance structure and enable the project company to be kept whole. Project finance projects will typically involve a head-contract, in the article called the concession agreement, between the procuring authority and the project company. The project company will then enter into subcontracts, usually an EPC (engineering, procurement and construction) contract and an operation and maintenance contract, which pass down the obligations in the concession agreement to subcontractors. This pass down is required as the project company is a special purpose vehicle and it is the subcontractors who will in practice construct, operate and maintain the asset.

The concession agreement will contain a date for completion of the works/commencement of the service. The EPC contract will similarly contain a date for completion. Failure to complete by a longstop date is normally an event of default entitling the procuring authority to terminate the concession agreement. Any longstop date in the EPC contract will be earlier, allowing the project company to potentially replace the EPC contractor and resolve any issues before it is itself at risk of termination at concession agreement level.

However, having such a buffer between the dates that trigger termination under the different contracts may raise concerns of how the project company will be compensated for losses it incurs after the EPC contractor is terminated, for example, continuing liability for liquidated damages under the concession agreement or the cost of debt service. For the project company to remain whole, it clearly needs to recover its losses from the EPC contractor to the extent that it is not able to cover this risk by insurance.

Generally under English law (it does, of course, depend on the drafting of the particular provisions) liquidated damages are an exhaustive remedy for delay. This means that the employer is unable to claim general damages for delay. What is less clear is what happens to liquidated damages on termination. One suggestion is that liquidated damages are recoverable up to the date of termination and afterwards general damages apply1. In a project finance scenario, this would enable the project company to recover any of its future losses by pursuing a general damages claim. An interesting question is whether a cap on the amount of liquidated damages precludes a claim for general damages after completion, in effect operating as a cap on damages for delay generally, rather than just a cap on liquidated damages. The drafting of the particular clause would surely be critical in determining this.

Clear and express contractual provisions should prevent any uncertainty over whether liquidated damages survive termination (if that is the parties’ intention) and what losses are recoverable on termination.

An alternative to recovering such losses as part of a general damages claim after termination may be to ensure that the liquidated damages payable by the EPC contractor prior to termination of the EPC contract cover the future liabilities of the project company to the greatest extent possible. This would allow the project company to avoid making a general damages claim.

It would, however, mean that the project company may not recover all of the post-termination damages it would have done by making a general damages claim, as agreeing on any rates of liquidated damages is a commercial negotiation which may in reality be lower than the parties’ genuine pre-estimate of loss and will certainly be influenced by market practice in terms of caps on the amount of liquidated damages and the parties’ view of the overall risk allocation of the project.

From a UAE law perspective, the issue is not so much of a concern, as liquidated damages provisions can be opened up and altered to reflect the employer’s true loss. While the flexibility of the UAE approach may have certain benefits, contracting parties should still attempt to agree an appropriate liquidated damages clause, as this will give them a measure of certainty and, in any case, it would be costly in terms of time and money to seek to challenge it retrospectively in the courts.

Conclusion

Careful consideration should be given to the drafting of liquidated damages provisions in general to ensure that they operate as intended, as well as to how the rates are calculated. In a project finance deal, liquidated damages in the EPC contract are a vital part of the ability of the project company to recover any losses it may incur as a result of an EPC contractor’s delay. The EPC contract needs to be carefully worded to ensure those losses are recoverable, whether by way of liquidated damages or by compensation post-termination.

Reference

1 Hudson’s Building and Engineering Contracts (12th Edition), paragraph 6-039.

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