Conditions for liquidated damages

Liquidated damages are damages which are decided among the signatories of the contract during the formation phase. They mention the damages which the injured party would be compensated for upon a specific breach (Late payments/deliveries etc).

In the case of the parties not identifying the damages for a specific breaches of the contract, the damages are then ascertained by the court .

Liquidated damages would hold true if the following two conditions are met;

The amount of the damages should be more or less of an equal amount to the actual damage , which are to be allotted to the party seeking them.

The damages mentioned in the contract should be determinable by both the parties at the time of the signing of the contract. This would save both the parties in estimating the damages on a future date. Such damages which cannot be calculated precisely are known as unliquidated damages. They are uncertain due to some unknown factors which the parties cant not predict or estimate.

Example: Suppose Hussain has promised to allot the first floor apartment of his new building “Creek City" to Wajiha Bari on the 1st of January. Wajiha wants the apartment no later than that date and due to some reasons she gets possession of her apartment by the 1st of March. Now it is extremely difficult to calculate or estimate the amount of damage Wajiha has bared due to the delay.

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] "

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." [2] 

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

To begin with, first both the parties need to agree to include the liquidated damages clause in the contract. To be able to bring both the parties to an agreement to its inclusion, the parties must decide on the type of damages which will be covered by the contract and the means of calculating them as well. You should be able to ascertain and aware of all aspects of your business so as to be able to draft the clause carefully. A multi business owner should take into account the effects of the contract on his other businesses and subsidiaries as well in calculating the damages. (eg: goodwill)

The owner must ask itself several questions:

What costs will be incurred by you if the contract is delayed and not completed on time?

What is the daily loss in sale and eventually in profits of your firm?

How much would it cost to cope up with the delay in delivery from the primary supplier in terms of getting a delivery from a backup supplier?

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

How much costlier would be the cost of financing due to an increase in the number of days for the payment of interest on loans etc?

Whether the breach of this contract is affecting your contracts with other third parties etc, if yes then what are the damages then?

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.