Examining Cases of Liquidated Damages Definition

Liquidated damages are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach (e.g., late performance).

When damages are not predetermined/assessed in advance, then the amount recoverable is said to be ‘at large’ (to be agreed or determined by a court or tribunal in the event of breach).

In order for a liquidated damages clause to be upheld, two conditions must be met. First, the amount of the damages identified must roughly approximate the damages likely to fall upon the party seeking the benefit of the term. Second, the damages must be sufficiently uncertain at the time the contract is made that such a clause will likely save both parties the future difficulty of estimating damages. Damages that are sufficiently uncertain may be referred to as unliquidated damages, and may be so categorized because they are not mathematically calculable or are subject to a contingency which makes the amount of damages uncertain.

Example: suppose Joey agrees to lease a storefront to Monica, from which Monica intends to sell jewellery. If Joey breaches the contract by refusing to lease the storefront at the appointed time, it will be difficult to determine what profits Monica will have lost because the success of newly created small businesses is highly uncertain. This, therefore, would be an appropriate circumstance for Monica to insist upon a liquidated damages clause in case Joey fails to perform.

Contract Act 1872

Clause no 74: Compensation for breach of contract where penalty stipulated for;

Penalty and liquidated damages: This section boldly cuts the most troublesome knot in the Common Law doctrine of damages. By the Common Law parties may name a penal sum as due and payable on a breach of contract, that sum being, according to the true intention of the parties, only a maximum of damages. In that case the real damages and no more, are recoverable. On the other hand, they may by consent assess a fixed measure of damages, liquidated damages as they are called, to avoid the difficulty that must often be found in setting a pecuniary value on obligations not referable, on the face of them, to any commercial standard

1.2 Sale of Goods Act 1930

Chapter 6: Suit for Breach of Contract;

Condition is a stipulation essential to the main purpose of the contract, the breach of which gives rise to treat the contract as repudiated. Warranty on the other hand is a stipulation collateral to the main purpose of the contract, the breach of which does not entitle the buyer to treat the contract as repudiated and give rise to claim of damages. Breach of condition may be treated as a breah of warranty but breach of warranty cannot be treated as breach of condition.

Liquidated damages clause comes under the breach of contract. The damages assigned to the type of breach made by either party are defined at the time of the contract making. It is one way of conflict resolution which both parties agree to by deciding on which factors the liquidated damages are valid.

2. Guidelines for formation and calculation of liquidated damages

Once the owner has made the decision to include a liquidated damages clause, it must consider the type of damages to be recovered and the calculation method. Whether the project that the owner is contemplating is a single prime or a multi-prime project, when it comes to calculating liquidated damage amounts for inclusion into a particular contract, the owner must know his project and all of its interfaces.

The owner must ask itself several questions:

If the contract is delayed, what additional costs am I going to incur?

How much lost revenue and profit am I going to lose per day?

What are my project administration costs going to be if I have to keep them on longer, which includes support staff, inspectors, rent, equipment, and overheads?

What is the probability of environmental fines being assessed, or additional permitting costs being incurred if the project is not completed on time?

What is the interest cost on any loan to finance the project?

What follow-on or third party contracts will be impacted if this contract is not completed on time?

Generally speaking, the types of damages that are recoverable include but are not limited to loss of use, lost rent, lost revenue and profit, permits and licenses, right-of-way costs, environmental fines, extended and increased construction loan financing, extended project administration, damages due to economic impact, and impacts to follow-on contracts. There are a multitude of acceptable methods and techniques that have been utilized to estimate damages for each type of damage listed above. No matter what method is utilized, the single most important question to be asked in order to ensure enforceability is: “Did the method represent a “reasonable” effort to forecast the damages the owner is likely to incur at the time of contract formation?” With that being said, all owners should also know by now that the words “penalty” and “liquidated damages” mix like oil and water and should never be associated with each other.

3. Legal standing of liquidated damages in Pakistan

3.1 state bank of Pakistan guidelines:

According to the State Bank of Pakistan guidelines for commercial banks, liquidated damages are allowed as per normal convention and as stipulated in the Contract Act, 1872 and Sale of Goods Act 1930.

For Islamic banking these guidelines are a bit different according to the SBP. According to the religious edicts and consensus that prevails on liquidated damages, Islamic banks are allowed to impose late fees on the defaulting clients but the proceeds generated from these must only go towards charity purposes.

The liquidated damages must always be based on actual financial loss for Shariah compliant banks. The loss cannot contain a component of lost opportunity cost. The financial loss thus must be proved by the bank to the court or arbitrator. Another variation that SBP provides for Shariah compliant banks is to allow them to fix the liquidated damage rate as the going rate on the bank’s Mudaraha portfolio. The financial condition of the defaulter must always be taken into account.

3.2 enforcement in case of dispute between parties:

Since Common Law system is followed in Pakistan, the court (or arbitrator) generally enforces the liquidated damages clause except in extreme circumstances. According to the long serving rule in the DUNLOP PNEUMATIC TYRE COMPANY LTD v. NEW GARAGE & MOTOR CO. LTD (1915) the court only has to decide whether the clause at time of construction of the contract was placed as a compensatory element or as a deterrent.

Of course in the case where the difference between the actual loss suffered and the stipulated liquidated amount is exaggerated, the court has the power to not follow through with total enforcement i.e. enforce the defaulter party to only pay the lesser or the actual loss amount. Or the court can turn the clause into a penalty clause (instead of a liquidated damage clause) which is unenforceable.

The court under the Common Law system is just content with making sure that for enforcement the liquidated damage clause is compensatory rather than deterrent.

4. Various examples of liquated damages

A penalty clause is unenforceable while a liquidated damages clause is.

4.1 Case in point:

DUNLOP PNEUMATIC TYRE COMPANY LTD v. NEW GARAGE & MOTOR CO. LTD

(1915)

Clause: Firstly that clause will be held to be a penalty clause “If the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.”

Pros:

Makes sure the clause is of a compensatory nature not a deterrent nature

Provides that a party is not able to take unfair advantage of the other party

Cons:

In some cases may mean that the aggrieved party is only compensated for perceived tangible losses but not genuine hidden intangible losses that can’t be substantiated fully in court.

The losses at the time of contract construction and the time when the breach occurs may have a vast difference and these may not be compensated for.

Liquidated damages are used to as ascertain future damages at the time of contract construction.

4.2 Case in point:

PHILIPS (HONG KONG) V. THE ATTORNEY GENERAL OF HONG KONG

(1993)

Clause: The damages must be sufficiently uncertain at the time the contract is made, that such a clause will likely save both parties the future difficult of estimating charges.

Pros:

This provides protection to parties such as fledgling business that maybe uncertain of profit margins

It saves the aggrieved party time in enforcing this clause as long as the breach has occurred.

Cons:

The losses at the time of contract construction and the time when the breach occurs may have a vast difference and these may not be compensated for.

5. Liquidated damages- cases in Pakistan.

WAPDA VS INDEPENDENT POWER PRODUCERS (IPPS)

(January 2010)

The short supply of fuel attributed to power shortage by the Independent Power Producers (IPPs) especially the Kot Addu Power Company (KAPCO) which is likely to face Liquidated Damages (LD) claimed by WAPDA for running the plant below capacity. It will be interesting to note that at the time when WAPDA is claiming LD from KAPCO, the state owned WAPDA owed KAPCO in excess of Rs27 billion. The final decision regarding this case is still pending.

The rift between government and Independent Power Producers (IPPs) is feared to be intensified in case WAPDA insists penalizing some of the IPPs for not meeting the agreed amount of power supplies. The IPPs in question have their own point of view on disrupted power generation due to insufficient fuel supplies on the part of the government which is the root cause of shortfall in power supplies. WAPDA may impose liquidated damages (LD) on KAPCO on account of low load factor in the financial year 2009. Notwithstanding KAPCO& its legal advisors were of the view that the imposition of Liquidated damages by WAPDA was not justified, hence the damage claims might lead to a strained relations.

KAPCO’s Power Purchase Agreement (PPA) stipulates that the company would be liable to WAPDA for LD if it happens through a fault of its own, while KAPCO was unable to meet mandated electricity dispatch. However this could be attributed either to capacity de-rating and inability to meet the capacity test on account of poor maintenance or such fault of the company or forced power outages at any time in which case power supply to WAPDA was curtailed. Contending the damage claims, KAPCO pleads that WAPDA’s claim is unfounded as the reason KAPCO has lower load factor in FY09 (66% vs. >70% in last 4 years) was because of limited fuel supply. The fuel supply limitation was only because of WAPDA payment delays. KAPCO has also taken WPPO (WAPDA Power Privatization Organization) on board and both parties have completed an analysis which concluded that: “KAPCO could operate at almost 100% capacity if supplied fuel however the reduction in dispatch was only because of non-availability of fuel”.

JAPAN POWER GENERATION LIMITED (JPGL) VS WAPDA

(February, 2010)

JPGL is locked in a bitter dispute with Wapda over its claims of “liquidated damages”. The company, last month referred the matter to the International Court of Arbitration under the International Chamber of Commerce’s (ICC) Rules as per the provisions of the PPA for breach of contract by the other party.

Japan Power Generation Limited (JPGL) the power complex that was for over a year had resumed operations from Feb 6 “following the payment of interest bearing advance from Wapda/Pepco for the purchase of fuel and spares”. The 120.5MW oil-fired power station located off Raiwind Road, Lahore, was out of commission since December of 2008.

The plant had started to generate electricity because of provision of funds by Wapda/Pepco. But the management cautioned that the ‘contingent liabilities’ detailed in the company’s annual accounts, 2009 remained to be settled.

In the last annual report for the year ended June 30, 2009, directors of JPGL had complained to the share- holders: “Your Company is in extreme financial distress due to the ongoing dispute with Wapda, whereby Wapda has completely stopped payments from Jan 2009 onwards. This is a departure from Wapda’s obligations under the Power Purchase Agreement (PPA)”. The management said that looking at the country’s dire need of electricity; numerous initiatives with Wapda were taken to re-start operations of the plant.

6. Liquidated damages — The importance of getting it right

Providing contractual certainty: Pakistan these days is facing major crises in terms of credibility. This lack of credibility has added to the transaction cost such as L/C’s and financing. Besides this, country with flawed legal system adds to risk premium thus foreign countries are reluctant in doing business with Pakistan. A fool proof clause of liquidated damages in the contract would address all of these issues as higher degree of contractual certainty would be granted.

Simplifying disputes: With liquidated damages losses are estimated ex ante, (at the time of contracting). Such clauses avoid that judges have to compute the damages ex post. It is well known that judges may have serious difficulties in finding out the true losses. This holds especially for subjective harm. It is impossible for a judge to know the promisee’s preferences precisely. Nor can he rely on what the promisee tells him, because the latter has no incentive to reveal his preferences in an honest way. This kind of preference revelation problem does not arise when the loss is determined ex ante. This issue holds vital position when we are considering a developing economy like Pakistan which is already overburdened and is facing serious strains on its resources. Thus incorporating this clause will help save nation’s resource as incase of breach of contract, the matter will be resolved by the parties themselves.

Inducing performance: Liquidation damages are available to non breaching party if agreed at the time of contract. The presence of such clause in the contract will likely to stimulate performance. This is typically true keeping in mind the Pakistani culture and mind set where the primary motivation of businesses to deliver on time is the fear of facing monetary damages or losses.

Thin line between penalty and liquidated damages: to be enforceable the quantified amount of liquidated damages must be a genuine pre estimate of loss, because if a court considers that the amount is excessive it may categorize it as being a penalty, then the liquidated damages clause will become unenforceable and its benefits will be lost.