It’s all about the money: Liquidated damages and the cost of delay in construction projects

Introduction

Delays on projects are often unavoidable and their impact can be both significant and costly. To mitigate the risks associated with delays, construction contracts often include liquidated damages (LD) provisions, which serve as a practical mechanism to pre-determine the financial consequences of specific breaches. In doing so, they incentivise contractors to complete works on time, whilst also providing employers with some financial recompense should works be delayed.

While LD clauses can offer an efficient way to address potential delays, their enforceability and application are not without complexities, particularly in jurisdictions like the Middle East. It is crucial therefore for all parties to understand the specific role of LDs and how LD claims are managed under local laws and practices, which, it should be noted, differs from the treatment of LDs under the laws of England and Wales.

In this article we explain the typical approach to LDs in the Middle East and provide some practical guidance on negotiating LD provisions in contracts and managing LD claims.

What are liquidated damages?

LDs allow contracting parties to predetermine the financial consequences of a specific contractual breach. They are distinct from general (unliquidated) damages, which are not fixed in advance and are awarded by a court or arbitral tribunal based on proven actual losses, requiring evidence of both the breach and the resulting harm. 

In contrast, LDs are fixed in advance to cover anticipated losses resulting from specific breaches such as delays, performance shortfalls, or lack of availability. These are pre-agreed sums stipulated in the contract (with their maximum value often capped), payable by the contractor to the employer when such breaches occur. To put it simply, LDs operate as a pre-determined debt obligation that is automatically triggered when a specific contractual breach (and on most projects this is a failure to complete the works by the Time for Completion but may also arise due to failure to meet certain performance standards) occurs.

Typical practice in the Middle East

The LD arrangements or mechanisms commonly found in construction contracts in the Middle East  include one or a combination of the following:

• a fixed amount per day or week of delay
• a maximum cap set as a percentage of the contract price
• the ability to make deductions from interim or final payments to the contractor through set-off rights
• security through a performance bond or bank guarantee provided by the contractor

In the UAE and Saudi Arabia, the common market practice is to cap LDs at 10% of the contract price. This practice is generally considered a fair estimate of potential losses and frequently appears in both FIDIC-based, as well as bespoke, construction contracts. Having said that we have seen instances where LDs have been capped at 100% of the contract price.

In practice, employers view the cap as both a safeguard against delays or performance shortfalls and a form of guaranteed minimum protection. Contractors, on the other hand, often accept it as a commercial compromise, even if it may not precisely reflect the actual cost of the breach to the employer.

The enforceability of liquidated damages clauses in the Middle East

Courts in both the UAE and Saudi Arabia typically uphold LD clauses as valid expressions of the parties' negotiated agreement, however LD provisions are not immune from scrutiny.

Under UAE law, whilst parties are free to contractually agree the amount of LDs that will be payable, the courts retain the power to intervene if there is clear evidence that the actual loss suffered by the recipient party is either significantly less or significantly more than the amount of LDs specified in the contract. In such cases, a court may reduce or increase the level of LDs to reflect the actual harm caused by the breach.

In Saudi Arabia, while Sharia principles historically guided contractual remedies, the recent introduction of the Civil Transactions Law has brought greater legal certainty. Under the legal framework, parties may agree in advance on compensation for contractual breaches, including delay. However, like the UAE, the Saudi courts maintain discretion to adjust the agreed amount if the actual damage is shown to be substantially different from the pre-agreed sum.

Key points when drafting liquidated damages provisions

When negotiating or administering construction contracts with LD provisions, parties should consider the following:

• Employer’s right to recover LDs: set out the rights of an employer to recover LDs in the contract. Specifically, the contract should grant the employer the right to:
  
  • Deduct LDs from any interim or final payments: the employer should be be entitled to deduct the amount of LDs it is due from any interim or final payments that it is obliged to pay the contractor. If the employer has such a right of set-off, the contract should specify the timing and procedure for such deductions to avoid disputes regarding the amount or timing of payment.
  • Recover LDs as a debt: if the deductions from interim or final payments due to the contractor are insufficient to cover the full amount of the LDs, the contract should allow the employer to recover any remaining LDs as a debt.
• Clarity in triggering events: clearly define the specific events that give rise to LDs. The most common event is the contractor’s failure to complete the works by the contractual completion date in circumstances where the contractor does not have an approved extension of time (EOT). LDs may also be triggered by other breaches by the contractor such as performance shortfall (i.e. failure to meet required output or quality standards) or lack of availability (i.e. failure to make systems or facilities operational for use).
• Select an appropriate method for calculating LDs and set a clear cap: determine the method by which LDs will be calculated which should reflect the nature and impact of potential delays or other breaches. Typically, LDs are set at a fixed daily or weekly rate, which should correspond to a reasonable estimate of the employer’s anticipated loss resulting from delay or non-performance i.e. loss of revenue, additional financing costs, or disruption to downstream operations. LDs are also commonly subject to a maximum cap, for example, a percentage of the contract price.
• Contract value vs. contract price: determine which figure will be used as the basis for calculating LDs and any associated cap as this can have a significant impact on the amount payable. The contract price represents the price originally agreed for the scope of work, whilst the contract value may encompass additional elements such as variations, provisional sums, and contingencies – clarity on which of these is to be used as the basis for LD calculations is key!

Conclusion

LDs are an essential tool for managing and responding to project delays. However, as can be seen, LD claims require careful consideration and planning and there should not be a blind expectation that a court or tribunal will give effect to the terms of an LD clause.