Liquidated Damages & Penalty Clauses in the Construction Industry
Our Associate, Hisham Almansoor explains liquidated damages and penalty clauses in the construction industry.
Hisham Almansoor – Associate ([email protected])
The construction industry is a significant component of the Bahraini economy with local and foreign investment in new residential and commercial projects continuing to proliferate through the years. GDP from construction in Bahrain averaged BHD214.06 million from 2012 until 2022, reaching an all-time high of BHD240.49 million in Q2 of 2022. Yet with the important part of the Bahraini economy comes an ever-lasting concern on the issues that may arise during the course of construction projects. Contracts concluded between parties factor in the risk of disruptions and delays that may affect projects, which is why the FIDIC contracts envisage concepts such as time extensions. Liquidated damages are an amount determined by the Employer as a reasonable assessment of the actual damages he would suffer in the event of delay in the completion of the works. Article 225 of Decree Law 19/2001 on the Issuance of the Civil Code (“BCC”) provides “Unless the obligation is payment of an amount of money, the contracting parties may determine the compensation in advance in the contract or in any subsequent agreement.”
Administrative contracts
One of the primary limitations to a party seeking to rely on liquidated damages clauses is owing to the distinction made with contracts concluded with a government body. In these circumstances, the contract is deemed to be an “administrative contract” which is endowed with a special status and consequently the result of delays is afforded different considerations. The Court of Cassation notably held in Challenge No. 531 J.Y. 2021 that:
“It is established that the delay fine stipulated in civil contracts between persons of private law is an agreed upon compensation they may determine in advance, as long as the object of the obligation is not an amount of money, which differs from the delay penalty fine that the administrative body has the right to impose on the contracting party in administrative contracts. Said fine is due as soon as the violation for which the fine is prescribed as a penalty occurs, while the consensual compensation in civil contracts does not bind the courts.”
Furthermore, the Court of Cassation also held under Challenge No. 1522 J.Y. 2019 that:
“[Penalty clauses] are intended to ensure that the Contractor with the administrative body fulfills his obligations in order to ensure the regular and steady functioning of the public utility. The Contractor with the administrative body may not dispute its entitlement to a fine under the basis of the absence of damage or exaggeration in the estimate of the fine, unless it is proved that his breach of his obligations is due to a force majeure or to the action of the administrative body. Likewise, the judiciary may not interfere in the amount of the fine agreed upon […].”
The above rulings of the Bahraini Court of Cassation demonstrate that penalty clauses under administrative contracts are subject to little judicial scrutiny and the Contractor may excuse himself from the penalty fine by establishing that the delays are a result of force majeure or the fault of the other contracting party, being the government body.
No materialisation of harm or excessive assessment of damages
Another caveat to an aggrieved parties’ reliance on liquidated damages clauses is the fact that said party had in fact suffered no real harm, or if the clause overinflates the amount of damages that is payable in return for the harm suffered. Article 226 BCC provides “Damages fixed by agreement are not due if the debtor establishes that the creditor has not suffered any loss. The judge may reduce the amount of damages if the debtor establishes that the amount fixed was grossly exaggerated or that the principal obligation has been partially performed. Any agreement to the contrary shall be null and void.” The Bahraini Court of Cassation, providing more guidance on this principle in practice, held under Challenge No. 197 J.Y. 2006 that:
“The essence of [Article 226 BCC] is that the courts may reduce the compensation agreed upon in the [liquidated damages] clause in two cases: the first, if the debtor fulfills the original obligation in part and the second, if the debtor proves that the compensation estimate in the clause was exaggerated to a large extent. […] Whereas it is established that if the debtor has carried out some of the obligations he was committed to and failed to implement others, then his default in this case is considered a partial fault that allows the court to reduce the agreed compensation to the extent that is commensurate with the amount of real damage suffered by the creditor. […]”
It is therefore observable that the courts exercise greater discretion when the Employer seeks to rely on a liquidated damages clause when the contract in question is not an “administrative” contract as discussed above, and if the Employer has not suffered harm to give rise to a cause for compensation. Contrary to the general principle that burden of proof to establish the occurrence of harm lies on the creditor, the courts shift the burden onto the Contractor where there is a liquidated damages clause, such that the Contractor may refute the rebuttable presumption of harm. This has been explicitly confirmed by the Court of Cassation under Challenge No. 681 J.Y. 2010 wherein the court held that “[…] a liquidated damages clause is in essence an agreed upon compensation as a penalty for a breach of an obligation. However, this may not be deemed a source of compensation as the entitlement to the same is subject to the contracting parties’ assessment. The creditor is not given the burden of proving the harm, but rather the debtor bears the burden of proving that no harm had materialised, or that the assessment of damages is exaggerated [on the facts]”. Hence, the burden is reversed onto the Contractor because the parties have agreed that harm has occurred (thereby establishing a ‘rebuttable presumption’), however the Contractor is in a position to refute that the Employer had suffered harm, or compensation under this clause would be grossly exaggerated on the facts.
Partial performance and reduction of compensation
In addition to the over exaggeration of the damages suffered by the Employer, the courts may reduce the damages to be awarded pursuant to a liquidated damages clause if it is established that the Contractor has performed a substantial part of its obligations. This has also been confirmed by the jurisprudence of the Court of Cassation in Challenge No. 197 J.Y. 2006 wherein the court upheld an appealed judgment’s decision to reduce the damages awarded to the creditor where the debtor has partially fulfilled the obligation in question. In this instance, as it was established the Contractor had at the time performed 80% of its obligations (as further corroborated by expert evidence), the court exercised its powers under Article 226 to reduce the compensation from that agreed upon in the liquidated damages clause.
Termination of the contract
Finally, perhaps one of the key caveats to parties’ reliance on liquidated damages clauses stems from the termination of the project contract. When matters do not proceed as planned, certain projects are faced with an imminent threat of termination. When this contract is terminated and the Employer tries to claim damages under the liquidated damages clause, the courts do not implement the provisions agreed upon as the contract is legally no longer in existence. Accordingly, a claim for compensation would follow the rules of tortious liability, being a fault, harm and a causal link between the two. The Court of Cassation notably held under Challenge No. 576/577 J.Y. 2011 that “Where the obligation [to which the liquidated damages clause relates] is forfeited as a result of the recission of the contract, the assessment of compensatory damages does not occur in the light of such clause. When compensation is being claimed, the courts determine the same pursuant to the general rule that the creditor bears the burden of proving the occurrence and scale of harm suffered.” Accordingly, no rebuttable presumption of harm is applicable in these circumstances, and the Contractor may instead avoid liability by establishing that the delay was beyond the Contractor’s own control, whether this is due to force majeure, supervening events beyond the Contractor’s control, an act of a third party or the Employer’s own fault.
Concluding remarks
Liquidated damages clauses form a key part of negotiating commercial contracts between parties as well as construction contracts. Said clauses, however, are not a guaranteed right to receive compensation following a breach by the defaulting party, as when these clauses fall for the courts’ consideration, close scrutiny of the surrounding facts may entail that the aggrieved Employer does not receive the full liquidated damages as agreed between the parties. The main limitations to the reliance of said clauses are: (i) where the contract in question has been terminated (as the clause is no longer in effect), (ii) if the Employer has not suffered any harm (ie the Contractor refutes the presumption of harm suffered by the Employer), or (iii) if the assessment and award of damages based on this clause is exaggerated on the facts. However, where the contract is with a government body, the courts exercise little scrutiny as they are legally deemed to be “penalty clauses” under administrative or public works contracts as opposed to liquidated damages under regular civil contracts.
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