1. LIQUIDATED DAMAGES AND EPC CONTRACTS: A BRIEF OVERVIEW
Engineering, Procurement and Construction (“EPC”) contracts have become popular and more preferred way for the owners of major construction projects in complex sectors such as transportation, energy, irrigation, etc. since the contractors are, under an EPC delivery model, generally responsible for all design, engineering, procurement, construction and commissioning of the facility. Thus, an EPC contractor generally undertakes time, cost and quality risks whereas the owner undertakes the payment of the contract price and only needs to control the execution of the project as to any possible defect or dispute.
In EPC contracts, the contractor generally undertakes to deliver an entirely operational facility by a certain date or within a fixed period after the commencement of the works. The contract price of an EPC contract is mainly determined on a lump-sum price basis. Furthermore, the contractor of an EPC contract guarantees that the completed facility will have certain performance standards and the defective work and services will be rectified or re-performed as well.
On the other hand, the owner takes certain various risks although the contractor remains responsible for all works of the construction. For instance, any failure to perform the works or a delay in completion of the whole works or a section by the contractor usually results in the failure of the owner towards other parties as the owner may have under other agreements at the horizontal level (e.g. financing agreements). In major projects it cannot be easy for the owner to anticipate financial burdens on the project in advance or during the delay. In addition, as long as the project is delayed, the commencement of the operations of the project and cash flow are also delayed. In this regard, liquidated damages are requested from the contractors in almost every EPC contract in order to avoid future disputes with respect to the calculation of possible amount of the losses.
2. LIQUIDATED DAMAGE AS A PROTECTIVE MEASURE?
Principally, the concept of liquidated damages serves to determine a compensation amount which has been agreed by the parties in advance and which shall be payable in case a specific event occurs. It should be noted that, in such concept, the parties determine the amount of compensation before the actual amount of the damage becomes apparent.
Liquidated damages may be tied to a variety of criteria but the most commons for imposing liquidated damages are performance guarantees and project delivery rates (Kelleher) and they are intended to compensate the owner for loss and damage arising out of the contractor’s failure. Pre-estimate damages or losses that the owner will suffer in case of a delay or failure are determined during the negotiation period of the EPC contract between the owner and the contractor.
The delay liquidated damages may be determined on the basis of daily, weekly or monthly delays by considering the extra costs that may be incurred such as extra insurance charges, supervision fees, financing charges and losses for each period of delay. For example, if a contract between an owner and a contractor contains a liquidated damages clause in the amount of $1,000 per day, and the contractor is ten (10) days late in finishing the project, then the contractor will be liable to the owner in the amount of $10,000, despite the fact that the actual damages may be otherwise (Drewry, C. p.2).
In certain contracts, performance liquidated damages, which are calculated separately in accordance with a schedule or a formula, are regulated along with the delay liquidated damages. In such case, the parties may regulate sub-caps. For instance, the parties may determine the caps for each type of liability as thirty per cent (30%) of the total contract price while they determine the overall cap on both types of liabilities as fifty per cent (50%). The parties may also prohibit the claiming of consequential damages as those damages are recovered by liquidated damage. However, there is not any legal sanction for setting out clauses regarding the payment of damages in addition to the liquidated damages provided that both parties agree on it.
Although the liquidated damages seem as an advantage for the owner, the contracts including liquidated damages clause may not always be “owner-friendly”. Contractors do not prefer to enter into contracts with unlimited liability. Therefore, damages of the owner are subject to the maximum amount of the agreed liquidated damages for delay and failure of the contractor. In this regard, EPC contracts limit the liability of the contractors and this limitation cannot exceed even if the actual damage is more than pre-estimate damage to the extent allowed by applicable law. This limitation of liability will be different for each project depending on the projects’ features and characteristics and mutual agreement of the parties of EPC contracts. Generally, the overall liability cap is not more than one hundred per cent (100%) of the contract price.
3. GENERALLY ACCEPTED ELEMENTS FOR LIQUIDATED DAMAGES IN INTERNATIONAL PRACTICE
For valid and well-established liquidated damages clauses, it is significant to consider three (3) main points; namely liquidated damage as penalty, prevention principle and certainty.
At first, understanding the differences between the liquidated damages and penalties is required to draft a valid liquidated damage clause. Penalties are generally disproportionate to the actual damage and serve as a punishment or as a deterrent against the contractor in case of breach of contract. On the other hand, as stated above, the purpose of the liquidated damages is to provide quick and easy way to compensate the owner’s loss rather than punishing the contractor. For example; under common law systems, if an amount is determined by the parties as liquidated damages but not as “genuinely covenanted pre-estimate of damage”, it may be interpreted that the liquidated damages clause has been re-characterised as an illegal penalty (Huse, p.275). In this regard, when the agreed amount is materially excessive, these clauses may be deemed unenforceable (12th American Law Reports) under common law systems.
The basis of this idea is that the owner should not benefit from the breach of the contractor. Therefore, the owner should pre-estimate the amount equal to the extent of its damages in case of breach of the contract. However, liquidated damages rate can be set less than genuine pre-estimate. At this point, it is important to state that the parties should be careful to consider the law applicable to the EPC contract regarding the implementation of liquidated damages clauses as some jurisdictions may tend to reduce the agreed amount of liquidated damages instead of deeming such clauses invalid.
Secondly, liquidated damages should not breach the prevention principle. Prevention principle is that the owner shall not insist upon the performance of an undertaking if this situation occurred due to the owner’s own breach of contract. As specified above, if the contractor fails to perform its obligation in due time, it will be liable for liquidated damages. The idea in this principle is to prevent the owners requesting liquidated damages from the contrac tors if the owner causes delay in contracts. According to common law practice, in case of delay or failure, the contractor will have the right to request the extension of time for the period of delay caused by the owner (Henry Boot Construction v Malmaison Hotel Case, 1999; De Beers UK LTD v Atos Origin It Services UK Ltd, 2010). Otherwise, the contractor will be released from the obligation to pay liquidated damages, in which case the owner will be precluded from claiming the liquidated damages as well.
Thirdly, liquidated damages clauses should set out certain and definitive terms such that the commencement date for payment of such liquidated damages as well as duration for payment thereof can be easily deduced from the EPC contract. Furthermore, it is significant to set out certain provisions regarding how liquidated damages will be enforceable considering the relevant law applicable to the EPC contracts.
4. LIQUIDATED DAMAGES UNDER TURKISH LAW
a. Delay liquidated damages
Implementation of liquidated damages under the Turkish law is not regulated as precisely as regulated under common law system. In this regard, Turkish Code of Obligations numbered 6098 (“TCO”) does not include an article specifying the difference between the penalty and liquidated damages nor it expressly defines the legal nature and characteristics of the liquidated damages.
Article 118 of the TCO spells out that the owner is entitled to request compensation for its losses and damages from the contractor due to delay in performance of its contractual obligations. However, the compensation articulated thereunder needs to be calculated after a dispute or claim arises amongst the parties. Despite the absence of any express article regarding the liquidated damages in Turkish legislation, the Court of Appeals (Yargitay) has certain resolutions allowing the application of liquidated damages. In this regard, the owner and the contractor may determine a compensation in advance and state the pre-determined compensation amount in the contract. In such case, this compensation is called by the Court of Appeals as fixed compensation (maktu tazminat) or lump-sum compensation (götürü tazminatı) which are almost identical to the concept of liquidated damages. In this type of compensation, as stated above, the pre-estimate amount is determined for the possible damage that may be suffered by the owner due to delay in performance of the contractor.
It should be noted that the Court of Appeals (Dep. 15, 6894/227) had an approach to allow the validity and implementation of liquidated damages clauses in the agreements to a very broad extent until 2011. By this date, the Court of Appeals changed its approach and limited the implementation of liquidated damages in Turkish practice. The Court of Appeals (Dep. 15, 6894/227) ruled that the payment of liquidated damages to owners without any limitation is contrary to good faith and morals. It has been stated in such resolution that the payment of the amount specified as liquidated damages may not last for an excessive term as it does not anymore serve for the purposes of “compensation”. Therefore, the Court of Appeals had ruled that the judge must have the right to determine the amount of liquidated damages considering the case specific elements
b. Liquidated Damages: Compensation or Penalty?
Even though the Court of Appeals (Dep. 15, 88/3118) has an approach to validate the liquidated damages clauses under the agreements; the practitioners still hesitate whether a liquidated damages clause shall be interpreted as a penalty clause or damage clause. Accordingly, the judges have different approaches in Turkish law practice to implementation of the liquidated damages under the relevant contracts. For example, although the parties agree on a liquidated damages clause in the agreement, the judge may interpret such clause as a penalty or vice versa. The judge mostly takes into consideration the purpose and intention of the parties. On the other hand, one of the basic challenges of judges in implementing liquidated damages is how to differ the penalty from the liquidated damages. Therefore, it is of a great importance to set out differences of penalty and liquidated damages in Turkish law.
Main difference between penalty and liquidated damages is based upon existence of damage. Considering the liquidated damages are pre-estimate damages, the owner must incur damages as a result of the contractor’s failure to timely or duly perform its specific obligations (Court of Appeals, Dep. 11, 11465/4671). However, the owner does not need to suffer any damage in order to claim penalty from the contractor if it fails to timely or duly perform its contractual obligations.
c. Performance Liquidated Damages
Even though the performance liquidated damages are not specifically and/or explicitly governed under the Turkish law, it should be noted that the Court of Appeals allows the payment of liquidated damages in case the contractor fails to timely perform its specific obligations. However, as mentioned in the previous sentence, both the Turkish legislation and the Court of Appeals remain silent in terms of the liquidated damages for the performance guarantees. In other words, there is no provision or ruling setting out the terms and conditions for how to apply the liquidated damages clauses envisaged for failure of the contractor in providing the guaranteed limits of the performance of a facility or any part thereof.
d. Limitation of Limited-Liability
There is one more significant issue regarding the implementation of liquidated damages in Turkish law. As stated above the parties can set a provision which limits the liability of any party. However, Article 115 of the TCO states that “previous agreements which envisage the debtor to be relieved of his liabilities in case of his gross negligence shall be deemed void”. It means that even if the parties agree on the limitation of liabilities of the contractor with a certain amount of money, this provision may be invalid in case of gross negligence of the contractor. Therefore, if the contractor’s failure in timely and duly performance of its obligations is arising out of his gross negligence or wilful act, he may not be able to raise the limitation of liability as an objection.
5. CONCLUSION
In conclusion, to sum up briefly, owners under the EPC contracts, executed for major projects, may have various agreements with third parties, such as financiers. Considering the complexity of such projects, the owner may always face diverse risks coming out of such agreements due to the failure of the contractor under the EPC contract. In this regard, even one day delay caused by the EPC contractor may result in breach of the owner in agreements concluded with third parties. Furthermore, the owner may barely predict its damages as a result of such failure of the EPC contractor. Therefore, liquidated damages clauses may be alternative for owners to recover their damages from the EPC contractor.
In case the liquidated damages clauses are not properly and duly drafted, owners under the EPC contracts may not be legally protected as much as they expect and poorly drafted liquidated damages clauses may result in legal controversy in implementation thereof. Furthermore, the Court of Appeals accepts the existence of delay liquidated damages in Turkish law, whereas the existence of performance liquidated damages is debated thereunder. In addition, determining the calculation methods and formulas of performance liquidated damages is of great importance as it may be the sole remedy of an owner under an EPC contract if the facility does not operate as compromised by the parties. In this respect, the parties must carefully draft liquidated damages clauses considering the foregoing and determine a reasonable pre-estimated amount to make such clauses valid and enforceable.
References:
1. Thomas J. Kelleher, Jr.,Smith, Currie & Hancock, “Smith, Currie and Hancock's Common Sense Construction Law: A Practical Guide for the Construction Professional”, John Wiley & Sons.
2. Christopher S. Drewry, “The Availability and Enforceability of Liquidated Damages in Construction Litigation”, p. 2.
3. Huse, Joseph A., “Understanding and Negotiating Turnkey and EPC Contracts”, p. 275.
4. 12. American Law Reports 4th 891, 899.
5. Henry Boot Construction v Malmaison Hotel Case (1999), De Beers UK Ltd v Atos Origin It Services UK Ltd (2010).
6. Department no. 15 of the Court of Appeals, January 24, 2011, 6894/227.
7. Department no. 15 of the Court of Appeals, January 24, 2011, 6894/227.
8. Department no. 15 of the Court of Appeals, October 4, 1988, 88/3118.
9. Department no. 11 of the Court of Appeals, April 29, 2010, 11465/4671.
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