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Liquidated Damages and Penalties in the Middle East

Liquidated damages are widely used and recognised in construction contracts in the Middle East but it is unwise to rely on preconceptions based on familiar common law principles when considering the effect and impact of local laws. Max Wieliczko considers the pitfalls and highlights the differences arising from local legal principles.
Introduction Whilst some familiar legal concepts are reflected in Middle Eastern legal jurisdictions, there are some important differences. It is unwise for parties to assume that familiar contracts will be enforced with the same outcome under local law. The approach to preagreement of compensation for breach of contract is an area where local law may surprise the unwary.

Law in the Middle East Legal systems in the Middle East have a degree of commonality as they are founded on Islamic Sharia law and similar civil law principles; for example the UAE, Qatar, Kuwait, Jordan, Libya and Syria have adopted codes based on the Egyptian Civil Code. The influence of Sharia law distinguishes Middle Eastern civil codes from Western civil codes. Sharia is a Divine source of inspiration, embracing both ethical standards and legal rules, aimed at achieving fairness, justice and a proper balance of benefits between parties.

What are liquidated damages? Liquidated damages are a common law concept, whereby a fixed sum is pre-agreed as compensation for a specified performance default; most commonly delay, but sometimes performance shortfall, loss of availability etc. Most construction contracts require the Contractor to complete work within a fixed timeframe, with liquidated damages specified as a sum payable for each day or week of delay to completion.

Liquidated damages are a permitted exception to the common law principle that recoverable loss is restricted to the actual loss suffered by the innocent party as a consequence of the breach of contract. Provided the agreed liquidated damages reflect a genuine pre-estimate of the loss which the Employer might suffer as a consequence of the breach, they are normally fully recoverable; even if the Employer suffers no actual loss.

Advantages of liquidated damages Pre-agreeing the consequences of breach affords both parties certainty as to their liability in the event of default. In common law jurisdictions liquidated damages give the Contractor the comfort of a maximum cap on its liability for certain defaults, which helps the Contractor to determine its risk when fixing the Contract Price. The Employer also benefits from this pre-agreement, as it does not have to prove actual loss or causation, and will not fall foul of common law rules prohibiting recovery of losses considered too remote.

Is it a penalty? The Common Law perspective The principal defining feature of liquidated damages is that they must be intended to be compensatory in nature; so that, at the time they are agreed, they must not exceed the Employers realistically conceivable losses for the contemplated breach. Common law systems demonstrate an antipathy toward penalties, which are deemed unenforceable, and therefore to the extent that a liquidated damages provision is shown to be a penalty it may be held unenforceable. The essence of a penalty is that it does not relate to actual loss likely to be suffered by the innocent party, but is merely a pre-agreed amount fixed in the contract, intended to induce performance by punishing default. Nevertheless, where liquidated damages provisions have been freely negotiated by commercial parties, common law courts have demonstrated a marked unwillingness to interfere with the parties intentions, and there is a presumption that a pre-agreed sum fixed as liquidated damages will be recoverable. When such provisions fail, they tend to do so for mechanistic reasons, rather than because the amount fixed is, in absolute terms, penal. The burden of proof is on the Contractor to prove that the pre-agreed sum is a penalty.

The adjustment of pre-agreed compensation the Middle Eastern perspective Pre-agreed liquidated damages will in principle be enforceable in the Middle East, even when expressly labelled as a penalty. This is because, whilst Middle Eastern laws recognise and permit the pre-agreement of the financial consequences of breach, they make no conceptual distinction between penalties and liquidated damages. Liquidated damages under common law cannot be unilaterally adjusted after they have been agreed, nor can they usually be adjusted by the Court to better reflect the loss actually suffered by the innocent party. By contrast, and alarmingly for the unwary, Middle Eastern systems do allow for adjustment of pre-agreed compensation, because this reflects the Sharia principle of achieving fairness.

The Qatari Civil Code, for example, provides that the Court has a discretion to make no award of liquidated damages if the Contractor can prove that the Employer has not suffered any actual loss. The Court also has discretion to reduce the pre-agreed amount if it considers that it is grossly excessive, or if the original obligation to which the preagreed sum related has been partially fulfilled. Parties cannot contract out of these mandatory provisions. Furthermore, the Qatari Court can also in limited circumstances award damages above the pre-agreed level if the Employer is able to prove that the Contractor has committed fraud or some gross error/negligence. These reflect equivalent provisions under the Egyptian Civil Code. Similarly, the Court in the UAE may adjust a sum pre-agreed by the parties. The UAE Civil Code provides that the Court may, on the application of either party, adjust the preagreed amount so that it is equal to the actual loss. Again, parties cannot contract out of these provisions. Unlike the Egyptian and Qatari Civil Codes, there are no specified circumstances in which the Court will upwardly adjust a pre-agreed amount. However it is unlikely that it would be done unless the discrepancy between the predetermined amount and the actual loss is substantial. On the face of it, it would appear to be theoretically easier in the UAE, than in Qatar, or Egypt, to persuade a Court to make an upward adjustment, and no extreme default need be established as a precondition to upwardly adjusting a pre-agreed amount.

Implications and conclusions The Middle Eastern system could work, in different circumstances, to the advantage or disadvantage of the Employer or Contractor. An Employer may wish to fix high liquidated damages to ensure the Contractor completes on time, but the Contractor may take some comfort in knowing that, in certain circumstances, the Courts may hold these to be unenforceable or reduce them. Where a Contractor is faced with paying liquidated damages that exceed the Employers actual loss, it is clearly beneficial to the Contractor to have an opportunity to reduce the liquidated damages. An Employer on the other hand may be able to obtain excess damages beyond the agreed sum, closer to its actual losses, but the ease of doing so will depend on the particular jurisdiction. The ability to adjust the pre-agreed compensation takes away the certainty usually afforded in common law jurisdictions by a liquidated damages provision, and actual loss may have to be ascertained in accordance with local legal rules. However, such provisions still reverse the burden of proof from a position where no sum has been preagreed, and set a presumption for recovery of the agreed sum which has to be overcome if the amount is to be adjusted. Given these uncertainties it is clearly dangerous to assume that familiar contractual language and formats will give rise to the same predictable common law outcomes that we are used to, and a proper understanding of local law is key when negotiating contracts in the Middle East.

Key Points: Liquidated damages are a fixed amount pre-agreed in the contract as compensation for a specified performance default. Middle Eastern jurisdictions do not make a conceptual distinction between liquidated damages and penalties, which is alarming to those familiar with common law, where penalties are normally unenforceable. The key difference between common law and Middle Eastern civil codes is that the amount of pre-agreed damages can be adjusted by the Courts if the Employers actual losses are more or less than the amount in the Contract. In the Middle East liquidated damages provisions cannot be relied upon either as a cap on the Contractors liability, or as a certain amount recoverable by the Employer.

Max Wieliczko 0207 651 4639 Maxwell Winward LLP, 100 Ludgate Hill, London, EC4M 7RE