Commercial contracts have various damage claims in accordance with the terms and conditions of any contract in case of failure to fulfill within the scheduled completion time by any party to that contract, the breaching party to pay damages to the non-breaching party a specific amount of liquidated damages agreed upon in the contract deed.
Let us understand the meaning of the term ‘liquidated damages,’ liquidated damages are the damages in the form of money (agreed upon by parties to the contract at the time of signing the contract) to be paid by one party for breaching that contract to another party as a claim or damages. One of the plus points for the injured/non-breaching party is that he does not need to prove the loss he has suffered; the incompetence or failure on the part of the contractor/breacher is sufficient cause for a claim. The clause of liquidated damages is particularly incorporated in construction and real estate contracts. The employer can deduct a specific amount from the contractor for not performing his duty within the stipulated time designated in the contract. It is to be noted that the liquidated damages clause is assumed to be ancillary contractual obligations until and unless a cause of action (i.e., late performance) does not arise; this clause is unenforceable by law.
In the UAE, the liquidated damages’ enforceability is addressed in Article 390 (1) of the UAE Civil Code 1985, Federal Law No. 5 of 1985 (the UAE Civil Code). The said article has clearly set forth law for the liquidated damages. The provisions of the law state that the parties to the contract can fix the sum payable in the form of compensation/liquidated damages at the time of formation/ signing of the contract or later on by way of agreement, subject to the provisions of the law. Article 390(2) lays down that the court, upon application of any party to the contract, can vary such agreement to make the compensation equal to loss incurred by the injured party and any agreement contrary to law such as the disproportionate amount of damages claimed shall be void.
The UAE law empowers courts to change the agreement by legal support all together to ensure that the compensation is equal to the loss sustained by the party and discretion to adjust the payment provided in the liquidated damage clause. Parties are bound to follow the court orders. The court orders have an overriding effect on the agreement between the parties under Article 390 of the UAE Civil Code because it is the law that governs the liquidated damages agreements. The restrictions regarding the liquidated damage clause in the UAE law are based on Islamic law; according to Article 7 of the UAE’s Constitution of 1971, the Sharia laws are the “principle source of legislation in the UAE.
According to Islamic Law, compensation will only be granted where the damages can be calculated, substantiated, and only in the amount suffered; it should not exceed the party’s injury. Subsequently, the liquidated clause conflicts with the principle of Gharar(uncertainty). Following the principle of Gharar, an agreement that comprises the risk of one party benefiting or bearing loss due to unknown and unforeseeable circumstances is not permissible. Because at the time of drafting or signing the contract, it is impossible to accurately determine the amount as liquidated damages for a breach of contract by any party. This pre-agreed amount in the liquidated clause might exceed or be inadequate to the injured/non-breaching party’s loss. This act amounts to infringe the principle of Gharar(uncertainty) under Islamic law and could be the reason to declare the liquidated clause void for being uncertain in nature but can be corrected by the court through adjusting compensation by keeping in view losses incurred by the injured party. It could set aside this clause if it proved that the injured party suffered no actual loss. However, due to its standing as a commercial and financial hub, the UAE, especially Dubai, has numerous international organizations and law firms with a common law background; these influence common law principles in the UAE in the drafting of contracts and agreements.
These common-law principles might conflict with the Islamic laws in various aspects, and it is a great challenge in the UAE to deal with.
Under the traditional English Law, if the liquidated damages clause constitutes any penalty, it would not be enforceable. This principle was established a century ago, in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co, which suggested that liquidated damages provision would be unenforceable if the amount payable is referred to as penalty. The penalty rule hinders the freedom of parties to fulfill the contractual obligations. This traditional approach has been quietly changed in the UK and common law jurisdictions, but the basic principle of unenforceability of penalty is still intact. Whereas, the test to determine whether a liquidated damages clause is a penalty or an authentic pre-estimated amount designated at the time of formation of the contract by the parties to the contract, the objective should be decided at the time of the drafting of contract by the parties to avoid any ambiguity in future regarding the liquidated damages, if one party breaches contract shall be liable to pay the other party pre-decided liquidated damages. The innocent party is not liable to prove that it has actually incurred the loss provided in the liquidated damages clause.
The English Law allows parties to contract to agree at the time of contracting, the specific amount to be paid if one party breaches the contracting by non-performing the contract according to the contract’s provisions or within the stipulated time defined in the contract in the form of liquidated damages clause. It protects the innocent party from suffering any loss due to the other party’s breach of contractual obligations. Its other objective is to deter other parties from breaching a contract. If one party breaches the contract, it terms to be a primary obligation. This primary obligation gives rise to the secondary obligation referred to as payment to the innocent/injured party. The employer/innocent party can deduct a sum from the contractor. The courts have also stressed that the rule of penalty is concerned with the secondary obligation of payment of compensation; it is not directly involved with the primary obligation of breaching the contract. It is a contractual remedy for breach of the contract. Liquidated damages are applied universally in the real estate and construction sectors.
The objective of incorporating a liquidated damages clause in a contract is to protect and compensate an employer for the loss he suffers due to delay in construction. The pre-determination of liquidated damages favors the employer/innocent party because he would be required to prove how much actual loss occurred due to breach of contract. The onus of proof is on the contractor/breacher to show that the compensation is unproportionate to the employer’s loss. Courts can reduce the amount by looking into the matter and the facts. Similarly, the UAE laws also practice this rule, where courts have the discretion to reduce the amount pre-decided by the parties when signing the contract if the amount is in excess of the loss suffered by the employer and turn down the provision if it is a penalty. However, the employer gets remedy, courts do not leave him remediless.