Liquidated damages
Chen Han Toh, Partner, and Frédéric Gillion, Partner, Pinsent Masons
PROVISIONS obliging one party to pay a specified sum to another where the first party has not performed a contractual obligation are widely used in construction contracts as a means of compensation for delayed completion and breach of guaranteed performance standards. In the Commonwealth and the US, they are often called ‘liquidated damages’. In many civil law countries, they are called ‘penalties’.
The International Institute for the Unification of Private Law uses the more neutral associated terms ‘agreed payments’ and ‘specified sums’. These sorts of provisions play a vital role in the balancing of risk associated with contractual nonperformance that is in modern times widely recognised in commercial contracting.
Agreed payments are susceptible to challenge
National laws vary considerably with respect to the validity of the type of agreed payment clause in question, but there are various ways in which agreed payment provisions may be challenged under both common law and civil law frameworks. However, due to the modern recognition of the legitimate purpose of agreed payment clauses, generally speaking, raising successful challenges is difficult.
As a general statement, civil law countries, and many states of the US, and in the US federal realm too, tend to focus more on the retrospective reviewability of the ‘specified sum’ rather than the validity of the clause altogether. Indian law also envisages the power to moderate a defaulting party’s liability where the tribunal applying the governing law considers it fair to do so even though the parties have agreed a ‘penalty stipulation’. The laws of many other Commonwealth territories remain focussed on the validity of the clause altogether.
Although, as mentioned, the law increasingly favours the upholding of a freely-agreed ‘liquidated damages’ clauses, nevertheless, there remain recent instances of successful challenges. In this article we consider five main grounds for challenge.
The rule against penalties
In most Commonwealth territories, ‘liquidated damages’ provisions will be unenforceable if they constitute penalties for breach. However, there are now two divergent approaches to the penalty rule across the Commonwealth.
Prior to 4 November 2015, in English law, as well as under the laws of many other national and subnational territories of the Commonwealth, the traditional test for penalties, which derives from the Dunlop case of 1915, required that the agreed payments represent a genuine pre-estimate of the likely loss as assessed at the time of contracting. However, on 4 November 2015, the UK Supreme Court in the case of Cavendish modified the test.
In most Commonwealth territories, ‘liquidated damages’ provisions will be unenforceable if they constitute penalties for breach.Thereafter, ‘liquidated damages’ would only be unenforceable, as a ‘penalty’, if the sum agreed was out of all proportion to any legitimate interest of the innocent party. Senior courts in major Commonwealth jurisdictions, such as Australia, the Hong Kong S.A.R. and New Zealand, have since adopted the variously formulated tests postulated in Cavendish.
Recent cases in the Technology and Construction Court of the High Court of England and Wales have demonstrated the difficulty of meeting the restated penalties test where the agreed liquidated damages have resulted from negotiation between sophisticated commercial parties. In contrast, the Singaporean High Court has declined to adopt the Cavendish test, and instead it retains the ‘genuine pre-estimate of loss’ test formulated over one century ago in Dunlop.
The position is plainly different in civil law jurisdictions where agreed payment clauses are recognised as having the following two major functions. Firstly, not only a compensatory function, as under common law, but also an incentivising function. Agreed payment clauses that include a punitive element will therefore be enforceable on the face of it. That said, most civil jurisdictions recognise the power of the judge to reduce the penalty amount if it is manifestly excessive, or if part of the main contractual obligation of the contract has been performed. Examples of this include the powers provided under article 1231-5 of the French Civil Code and article 390(2) of the UAE Civil Code.
The Council of Europe sought to harmonise this judicial control in a resolution in 1978 entitled ‘Relating to penal clauses in civil law’. This pan-European resolution aims at recommending a uniform application of penalty clauses for member states to use. The explanatory memorandum to the resolution provides a list of factors in determining whether a penalty is manifestly excessive. They include the comparison of the pre-estimated damages to the damage actually suffered, the legitimate interest of the parties, and whether the non-performance of the obligation was in good or bad faith.
Uncertainty
The English common law, and also those common law systems that closely follow English case law, will not save a liquidated damages provision that is hopelessly vague. That said, the laws are slow to condemn even a clause that reveals seriously inept drafting.
The English common law, and also those common law systems that closely follow English case law, will not save a liquidated damages provision that is hopelessly vague.‘Uncertainty arguments’ are often difficult in practice due to a general desire to uphold commercial bargains. A provision will be adjudged void for uncertainty only if, despite diligent and commercially-sensible efforts, the tribunal applying the governing law is quite unable to ascertain the parties’ objective intentions.
In view of the ‘high bar’ to defeat a liquidated damages clause based for lack of certainty, on one hand, a tribunal applying the governing law would not strike one down even if the calculation of the aggregate liability for damages is cumbersome. On the other hand, a common law tribunal applying the governing law is unlikely to enforce a liquidated damages provision if it is impossible to determine from that provision, properly construed, what rate should be applied. Examples of uncertain provisions include where a range of rates are stipulated without any indication of how the range should be applied, and where liquidated damages are specified in respect of a section of works the scope of which cannot be ascertained.
The position under civil law is generally similar in that the tribunal applying the governing law will try to determine the mutual intention of the parties in the case of ambiguity. However, civil law tribunal possesses greater powers to examine both pre- and post-contractual extrinsic evidence, which may reduce the likelihood of a clause being found unenforceable for uncertainty.
Non-compliance with conditions precedent
Many legal systems accommodate an outcome whereby an agreed payment is unenforceable due to the aggrieved party’s failure to satisfy contractually specified conditions precedent to the recovery of the specified sum. Commonly, in the constructing and engineering world, those conditions precedent take the form of mandatory contractual notices such as noncompletion certificates or pay-less notices. Challenges of this sort invariably turn heavily on the wording of the contract, particularly, whether or not any stipulated notice requirements constitute strict conditions-precedent to the entitlement to agreed payment.
There is an institutional trend moving away from ‘trigger hair’ time-barring clauses. This trend is noticeable in sub-clause 20.2 of the FIDIC second editions 2017, which sets out to ameliorate the effect of a party’s, though not only a contractor’s, non-compliance with the form and content requirements of a claim notice.
While many civil law jurisdictions will uphold conditions-precedent on the closely linked principles of ‘freedom of contract’ and ‘agreements must be kept’, civil law tribunals applying a civil code are generally less strict in enforcing notice provisions, especially if a party has acted inconsistently with the requirements of a relatively vital doctrine of good faith.
The prevention principle
The ‘prevention principle’ states that a party cannot insist on the fulfilment a contractual condition that, through a so-called ‘act of prevention’, it has prevented the other party from fulfilling. In the context of agreed payment provisions concerned with the late completion of construction or engineering works, delays caused by the employer which prevent the contractor from meeting the specified completion date may well constitute ‘prevention’ that undermines the employer’s right to recover the agreed payment arising from late completion.
In view of the ‘high bar’ to defeat a liquidated damages clause based for lack of certainty, on one hand, a tribunal applying the governing law would not strike one down even if the calculation of the aggregate liability for damages is cumbersome.Where true prevention exists, the employer’s access to the agreed payment might survive if the parties have clearly evidenced their common intention to hold the contractor liable notwithstanding employer prevention, or where the contract contains a mechanism to extend the time for completion on account of the relevant employer prevention. Opportunities nevertheless remain for contractors to challenge agreed payment provisions in construction and engineering contracts where the extension of time provisions are lacking, defective, or inoperable.
Although there is no direct equivalent of the prevention principle in civil law, generally speaking, one of the various expressions of a doctrine of good faith will typically be invoked by a contractor to challenge the application of agreed payment in circumstances where the employer is truly responsible for the contractor’s non-performance or delay in performance of contractual obligations.
Depending on the wording of the article of the relevant civil code dealing with the payment of damages for non-performance or late performance, a contractor may also argue that the non-performance or delay was caused by an ‘external cause’ – a ‘cause étrangère’ under article 1147 of the French Civil Code prior to its reform in 2016. This external cause could include, for example, a fault attributable to the employer, which would then exonerate the contractor totally or partially from the payment of liquidated damages. It would not, however, eliminate the application of the penalty clause altogether.
Waiver or estoppel
An employer may be prevented from recovering agreed damages on the ground that it has freely, unconditionally, and unequivocally, waived its right to do so; or because it is precluded by law – ‘estopped’ – from doing so. Waiver and estoppel arguments depend heavily on detailed factual evidence and applicable principles of documentary interpretation. Above all, they are dependent on the proved existence of unconditional and unequivocal evidence demonstrating the intentions of the party seeking to be paid.
An employer may be prevented from recovering agreed damages on the ground that it has freely, unconditionally, and unequivocally, waived its right to do so; or because it is precluded by law – ‘estopped’ – from doing so.
There are some recent instances of successful challenges to the enforcement of common law liquidated damages claims on grounds of waiver or estoppel. These include a telephone conversation which was found to constitute a binding oral agreement not to seek liquidated damages, and a taking-over certificate issued by the employer which stated that no liquidated damages were due.
In a similar manner to the common law doctrines of waiver and estoppel, an employer may be prevented from recovering a specified sum if it has violated the civil law principle of loyalty and the duty to act in good faith, both of which prevent a party from contradicting itself to the detriment of the other party.
Managing the risks of liquidated damages
The areas to watch out for with agreed payment clauses can generally divided into matters of drafting and quantification – the quality of the drafting and the adequacy and legitimacy of the specified sum. The administration of the contract and more particularly the activation of the agreed payment clause in a particular case of contractual default or non-default-based triggering are also relevant.
In cases of severe potential liability, and more so where there is a positive windfall gain for the party relying on the provision, the parties will assume diametrically opposed analyses of the wording and operation of these provisions. Accordingly, they are another species of contractual device that a prudent party will ensure receives timely expert legal attention.
Chen Han Toh, Partner, and Frédéric Gillion, Partner, Pinsent Masons
frederic.gillion@pinsentmasons.com