Turkey: Liquidated Damages Under EPC Contracts - Procrastinators Out!

By its very nature, an engineering, procurement and construction contract (an "EPC Contract") is a sophisticated form of construction agreement commonly used for realizing large scale infrastructure projects in complex sectors such as energy, transportation, irrigation, and so forth. Not only do the guarantees provided by the contractor under an EPC Contract make it attractive for the employer, but its "compact" and "safe" nature is also a key trait. In short, what we call an EPC Contract today is a contract in which the contractor assumes the design, engineering, procurement, construction and turn-key hand-over of a facility for a price; whereas, the main undertaking of the employer is to pay the contact price. Different from other forms of construction agreements, EPC Contracts provide broad undertakings for the contractor to facilitate the employer's life. Thus, EPC Contracts became a sine qua non in the Build-Operate-Transfer ("BOT") or Public Private Partnership ("PPP") projects that are project financed (i.e. where there is no, or limited, recourse to sponsors for repayment of financing), where multiple parties are involved, such as sponsors, investors, and public authorities, they rely on EPC Contracts in order to mitigate a projects' construction risks.

An "EPC Contract" itself is not specifically provided for under Turkish laws. Being classified as a "hybrid" contract, combining elements of several different contract types, several characteristics of EPC Contracts fall within the scope of agreements for work (istisna akti or eser sözleşmesi) set forth in Articles 355 to 371 of the Turkish Code of Obligations (the "TCO"), where one party (the contractor) assumes the obligation to complete a project, and the other party (the employer) undertakes to pay the contract price. The new Turkish Code of Obligations (the "New TCO"), which enters into force on 1 July 2012, brings with it novel procedures for most of the other agreement types; however, no substantial change is introduced in agreements for projects other than the increased period of limitation in the event of the contractor's gross negligence1.

In a PPP or BOT project, multiple parties assume various risks of diverse nature, such as political risk, currency risk, force majeure risk, commercial risk and, finally, construction risk, and distribute these amongst themselves, usually to the party who is best able to manage and absorb that risk. Although the parties' control over the former four risks is relatively low, the latter may still be managed through EPC Contracts.

The contractor's failure to complete the works within the pre-estimated timeframes and milestones constitutes one of the most important factors in construction risk. As noted above, EPC Contracts are preferred mainly in multi-party projects, where any delay of the contractor results in the employer's delay vis-à-vis another party at the horizontal level, and the project not being completed on time and in accordance with the financial model. Furthermore, as delays impose unanticipated financial burden on the projects, the funders will also be concerned about how these are dealt with under EPC Contracts. Among many others, another noteworthy concern is that continuous delays towards completion of the construction works will result in delays in the commencement of the operations of the facility and in the generation of cash flow.

In order to cope with these problems, liquidated damages provisions are used in EPC Contracts. Further, in general, the parties also tend to determine liability caps, i.e. the highest limits for which a contractor (or an employer) can be held liable. Nevertheless, labeling liquidated damages provisions as "employer-friendly" clauses are not appropriate. These provisions, in fact, serve both the employer and the contractor at the same time. Having these provisions in the EPC Contract, the employer can gauge exposure to any possible damage in the event of the contractor's delay in completing the works on time. In addition, in the event of a dispute, the employer will not be obligated to prove any actual damage or loss for indemnification. The contractor, on the other side, can foresee the furthermost limits of the liability that he assumes under the contract. However, generally speaking, several circumstances, such as the contractor's gross negligence, willful misconduct, claims that the contractor can recover compensation from his insurance companies, etc. are carved out from this limit and from the liability cap.

Both the TCO and the New TCO set forth similar provisions for a delay event. The main principle, which may be problematical for both parties, is that in the event of a delay, the employer can terminate the agreement prior to the determined expiry date or upon completion of the works. However, although it looks like a protective provision for the employer, terminating the agreement prior to the completion of the works may not be beneficial at all times.

Although the TCO entitles the employer to terminate the contract in the event it is clearly understood that the completion will be delayed, both parties of an EPC Contract would, most likely, not seek to break the deal at the first instance of distress. As we see in many cases, in a BOT or PPP project, the employer is under an obligation towards other parties (e.g., the public authority procuring the works, the institutions funding the project, etc.) to have the construction works performed and completed by a specific date and take the facility into operation status. Even in some cases, temporary underperformance of the works may also be preferable in order to achieve the milestones, rather than to terminate the contract. In addition, when the complexity of the projects and the number of different parties are taken into consideration, finding another contractor, and negotiating a new contract once again would be very time-consuming and cost-prohibitive.

Akin to the TCO, the provisions of the New TCO regarding contracts for work do not specifically provide for liquidated damages. On the other hand, the general provisions of the New TCO regarding contractual penalties, which, in general, repeat the relevant provisions of the TCO, enable the parties to provide liquidated damages provisions in the contracts. Accordingly, in the event a penalty is imposed for the contractor's failure to fulfill an obligation at a specific location, or by a particular date, the employer may require the contractor to pay the penalty even though he did not suffer any damages due to the contractor's delay, together with full performance of the uncompleted works.

We observe that, in general, the parties determine a fixed monetary amount as the contractual penalty. On the other hand, any formulation other than a monetary amount can also be stipulated in the contract; the amount of the penalty is not required to be explicitly set forth in the contract.

Both the TCO and New TCO allow the parties to a contract to freely determine the amount of the contractual penalty. In principle, in the event of a dispute, the court may decrease the amount of the contractual penalty. On the other hand, as per Article 22 of the New Turkish Commercial Code2, if the party who is obliged to pay the contractual penalty is a merchant (tacir)3 he cannot request a reduction of the contractual penalty amount. However, as per the general rule under Article 27 of the New Turkish Code of Obligations, the provisions of the contracts cannot be immoral or contrary to the obligatory laws, public order and personal rights. A similar provision is also set forth under Article 20 of the Turkish Code of Obligations. Accordingly, determining outrageous penalty amounts which result in the debtor's economic devastation might be considered to be an immoral provision by the courts, and the courts may decide to reduce the penalty amount or declare the penalty null and void.

In the event the employer incurs any damage higher than the penalty amount, the contractor will not be obligated to compensate such exceeding amount, unless the employer proves the contractor's fault as well as the damages amount that exceed the penalty amount.

Footnotes

1 According to the New TCO, in the event of a contractor's gross negligence, the period of limitation for the contractor's liability for defective work is 20 years for immovables. The TCO does not provide for a special period of limitation for a contractor's gross negligence.

2 The New Turkish Commercial Code will enter into force on 1 July 2012.

3 As per Article 16 of the New Turkish Commercial Code, those who operate a commercial enterprise in their own name are considered as merchant (tacir).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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