Recoverability of Liquidated Ascertained Damages Clauses in Construction Contracts -The Paradigm Shift in Judicial Attitude

INTRODUCTION

In building projects, the timely completion of construction works is of paramount importance to key stakeholders in the construction industry, i.e employers and project owners. Most employers forecast their profitability in placing reliance on the completion of projects in accordance with approved work programs. Failure by contractors to complete works on time would result in the employer sustaining financial losses. In addition, there may be exposure of liability to third parties, i.e by purchasers of a housing development for late delivery.

Most construction contracts, be it standard form or bespoke contracts contain provisions relating to liquidated ascertained damages (“LAD”). Parties to a contract may anticipate the possibility of a breach and include a term in their agreement stipulating that a certain sum shall be paid to the injured party by the party in default in the event of a specified breach. If the sum fixed is a genuine pre-estimate of the actual damage likely to be suffered by the injured party in the event of the specified breach, then it is recoverable and is known as LAD.

In Malaysia today, there are several schools of thought on the position of LAD, which therefore leads to the million-dollar question as to when a contract is breached by the defaulting party, should the innocent party bear the burden of proving actual loss and damages to justify their express entitlement to LAD or on face-value, the LAD clause ought to be treated as a genuine pre-estimate of loss and damages without the need for further proof.

THE MALAYSIAN POSITION AND SECTION 75 CONTRACTS ACT (“CA 1950”)

The Malaysian legal position on proving an entitlement to LAD is governed under S.75 of the Contracts Act 1950 (“S.75 CA 1950”) which provides as follows:

“When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.”

THE HISTORIC INTERPRETATION OF S.75 CA 1950 – SELVA KUMAR / JOHOR COASTAL

Under common law, LAD clauses are enforced as of right, while penalty clauses are struck down and the innocent party is required to prove its actual loss. In Malaysia, by virtue of s.75 CA 1950, the distinction between liquidated damages (“LAD”) and penalties are abolished, and the innocent party claiming damages must prove its actual loss as if the provision was a penalty.

Therefore, as previously reflected in the Federal Court cases of Selva Kumar a/l Murugiah v Thiagarajah a/l Retnasamy [1995] 2 CLJ 374 (FC) and Johor Coastal Development Sdn Bhd v Constrajaya Sdn Bhd [2009] 4 CLJ 569 (FC), it is trite that an innocent party intending to rely on a LAD clause must establish the following:

1. Establish that there was a breach of contract;
2. Prove “actual damage” (although not necessarily the quantum of its loss);
3. Justify the reasonableness of the stipulated sum or formula:

1. If the quantum of actual or real loss is capable of assessment, the innocent party will be entitled to such damages. If the innocent party fails to produce evidence to prove the loss which is capable of being so assessed, only nominal damages will be awarded; and

2. If the innocent party shows that it suffered some “actual damage” for which “there is no known measure of damages employable, and yet the evidence clearly shows some real loss inherently which is not too remote”, then the judge would be required to assess and determine reasonable compensation.

The two cases ultimately propound that the courts will only grant a sum which is reasonable as representing the plaintiff's actual loss. The cases seem to suggest that the plaintiff cannot recover simpliciter the sum fixed in the contract, whether as a penalty or LAD. Hence, in construction contracts, it seems necessary that the actual loss suffered on breach has to be established by the employer. Otherwise, the agreed would probably not be enforced, and the employer will only recover nominal damages if the actual loss cannot be proven.

The long and short of the original interpretation of s.75 CA 1950 is that the notion of freedom of contract is severely compromised as employer and contractor are not able to freely determine their respective rights, duties and risks as Employers are not allowed to freely enforce the sum fixed in the LAD clause without the need for further proof.

THE TIDES HAVE CHANGED WITH THE RECENT FEDERAL COURT CASE OF CUBIC ELECTRONICS

On November 2018, The Federal Court in Cubic Electronics v Mars Telecommunications Sdn Bhd [2018] MLJU 1935 (“Cubic”) had departed from the position in Selva Kumar and Johor Coastal through a different interpretation of Section 75 regarding LAD. In summary and for convenience, the principles that may be distilled are as follows:

1. Upon establishing a breach of contract, the sum stipulated in the LAD clause is subject to s.75 CA 1950;

2. S.75 CA 1950 allows for compensation to be provided by the court irrespective of whether actual loss or damage is proven. Thus, proof of actual loss is not the sole conclusive determinant of reasonable compensation although evidence of that may be a useful starting point;

3. The initial onus lies on the party seeking to enforce a LAD clause under Section 75 of CA to adduce evidence that firstly, there was a breach of contract and that secondly, the contract contains a clause specifying a sum to be paid upon breach. Once two elements have been established, the employer is entitled to receive a sum not exceeding the amount stipulated in the contract irrespective of whether actual damage or loss is proven subject always to the defaulting party proving the unreasonableness of the damages clause including the sum stated therein, if any; and

4. Should there be a dispute as to what constitutes reasonable compensation, the burden of falls on the contractor to show that the sum in the LAD clause and that the LAD clause stated therein is unreasonable.

Once the two elements have been established, the Employer is entitled to receive a sum not exceeding the amount stipulated in the contract, irrespective of whether actual damage or loss is proven, unless the Contractor proves the unreasonableness of the LAD clause including the sum stated therein.

Hence, the upshot of the Federal Court decision is that the original obligation placed on the Employer to prove actual loss has been dispensed with and that the tides have turned against the Contractor, as the burden rests now on them to prove that the LAD clause is unreasonable and/or exorbitant. With that being said, the Employer continues to bear the burden of proving the contractor’s breach of his completion obligations and the applicability of the LAD clause. In this regard, the overriding principle to which the Federal Court attempts to preserve is the notion of freedom of contract.

CONCLUSION: YOU MAY BE THE AUTHOR OF YOUR OWN MISFORTUNE

Given the ambiguity and substantial criticisms created by the decisions in Selva Kumar and Johor Coastal by placing a heavy threshold on the innocent party to prove actual loss, the Federal Court’s bold ruling in Cubic seems to suggest that the restatement of the traditional formula on liquidated damage clauses justifies a fresh look on the scope of S.75 CA 1950.

In the process, S.75 CA 1950 has been interpreted in line with modern commercial demands by preserving the very notion of freedom of contract which is the root of contract law. Parties to a contract can now look forward to entering a sensible arrangement with a view of having an understanding from the inception of where they stand in the event of a breach. This will avoid the burden of incurring heavy cost in proving actual loss if litigation ensues as courts will only intervene when the stipulated LAD sum is manifestly exorbitant.

PRACTICE POINTS: CAREFUL DRAFTING OF LAD CLAUSES

At the end of the day, while it goes without saying that the current judicial movement upholds the sanctity of contract, this consequently prompts careful consideration when drafting LAD clauses specifically in major construction contracts in view of Cubic. Hence, gleaning from a practical standpoint, there are several key takeaways when drafting LAD clauses:

1. Ensuring the stipulated sum in the LAD clause is proportionate with the contract sum and is not exorbitant;
2. Ensuring the wordings of the LAD clause is not unconscionable;
3. Although the obligation of proving actual loss has been dispensed with, it is still prudent practice to justify the reasonableness of the LAD clause by proving evidence of “actual loss”; 
4. It is prudent construction practice to keep documentation and records of extra-costs incurred to justify damage suffered by virtue of the contractor’s breach/delay;
5. Ensuring record of the basis of quantification to substantiate the reasonableness of the LAD stipulation;
6. Contractors should also be prudent to estimate the appropriate completion date/milestone to complete works in the construction contract as it has direct implication with the Employer’s entitlement to LAD; and
7. Contractors should ensure that the grounds for extension of time provisions in the construction contract are unambiguous and clear as it has direct implication with the Employer’s entitlement to LAD.