An overview and comparison of penalty stipulations in South African and UAE law and of the powers afforded to the courts of each country in respect of such contractual undertakings

Whether phrased as "liquidated damages" or a "penalty", the terminology is enough to make any tardy contractor shudder (or perhaps express a sigh of relief), and whilst the terms are often loosely lumped together as being synonymous, it is important to draw a distinction between them, especially because penalties are, in certain jurisdictions, simply unenforceable as a matter of law.

In the South African case of Pearl Assurance Co Ltd v Union Government 1933 AD 277 the Court drew a distinction between 'liquidated damages' and 'penalty' and held:

"If the object of the forfeit is to compel performance by fear of the consequences, it is a penalty; if it is genuinely to pre estimate damages it is not"

In South Africa, penalties and liquidated damages are readily applied and are regulated by the Conventional Penalties Act 1962.

Clause 1 of the South African Conventional Penalties Act 1962 states:

"A stipulation, hereinafter referred to as a penalty stipulation, whereby it is provided that any person shall, in respect of an act or omission, in conflict with a contractual obligation, be liable to pay a sum of money or to deliver or to perform anything for the benefit of any other person, hereinafter referred to as a creditor, either by way of penalty or as liquidated damages, shall subject to the provisions of this Act, be capable of being enforced in any competent court."

In the UAE, due predominately to the protection afforded by Article 390(2) of the Civil Transactions Law ("Civil Code"), and to the Arabic translation of the English phrases of 'penalties' and 'liquidated damages', the distinction is not readily made (if at all) between the concepts of a genuine pre estimate of damages, and a penalty.

Therefore for the purposes of this discussion and for ease, penalties and liquidated damages are cumulatively hereinafter referred to merely as a "penalties".

Penalty Stipulations under South African Law

As noted above, the Conventional Penalties Act 1962 regulates the imposition of penalties. Penalty provisions are especially prominent in the construction industry and are imposed on the delayed contractor should the contractor not complete the works by a fixed date. A predetermined agreed sum of money will then be levied (usually daily) until the contractor completes the work. Therefore a penalty will run automatically (no judicial intervention is required) and be applied to the period between the agreed date for completion and the actual date of completion. There is no duty or burden on the employer to prove any damage or loss, or even to prove that some loss was in fact suffered - the penalty provision is triggered upon breach of the relevant term by the contractor.

Penalties can be imposed on late completion of the works as a whole or to sections/milestones. Penalties can also be capped by a pre-agreed amount – usually a percentage of the contract price.

Therefore penalties under South African law need not reflect actual pre-estimated damage and accordingly, more often than not, have a punitive function.  However there is a small measure of legislative protection for the culpably late contractor, and whilst the courts are hesitant to interfere with contractual undertakings between parties in observance of the maxim pacta sunt servanda ("agreements must be kept"), section 3 of the Conventional Penalties Act 1962 provides the courts with a certain degree of power.

Section 3 of the Conventional Penalties Act states:

"If upon hearing of a claim for a penalty, it appears to the court that such penalty is out of proportion to the prejudice suffered by the creditor by reason of the act or omission in respect of which the penalty was stipulated, the court may reduce the penalty to such an extent as it may consider equitable in the circumstances: Provided that in determining the extent of such prejudice the court shall take into consideration not only the creditor's proprietary interest, but every other rightful interest which may be affected by the act or omission in question."

Through section 3, the Court is empowered to exercise discretion and to reduce the agreed penalty amount, if it appears to the Court that the penalty amount is out of proportion to the prejudice suffered. The amount to which the penalty is reduced, is in accordance with what the Court deems to be equitable. It is questionable whether arbitrators are able to exercise this power.

In Smit v. Bester 1977 (4) SA 937 (A) it was held that the burden of proof lies with the debtor to prove an absence of prejudice suffered by the creditor. Therefore it is for the debtor to prove that the imposed penalty is disproportionate to the prejudice suffered. This was confirmed in the later decision of Steinberg v. Lazard 2006 (5) SA 42 (SCA).

It is important to remember that the concept of 'prejudice' is wider than 'damages' and the debtor thus has a very heavy burden to discharge, especially as there is no obligation on the creditor to show that he himself has suffered any prejudice.

Penalty Stipulations in the UAE

In UAE law, provision is made under Article 390 (1) of the Civil Code for parties to agree in the contract as to the compensation payable should there be a breach of a specific contractual obligation. It must be kept in mind that the imposition of such compensation is a subsidiary obligation that only comes into effect upon breach of a primary contractual obligation.

Article 390 (1) of the Civil Code states:

"The contracting parties may fix the amount of compensation in advance by making provision therefor in the contract or in a subsequent agreement, subject to the provisions of the law.

However, as legislated for in South Africa, the court is also provided with a wide discretionary power to vary the agreement between the parties. This entitlement is set out in Article 390(2) of the Civil Code:

"The court may, on the application of either party, vary such agreement so as to make compensation equal to the loss and any agreement to the contrary shall be void." 

Therefore, either party may approach the court and request that the agreement between the parties, in respect of compensation payable, is varied to reflect the actual loss suffered: this would appear to provide a way for the penal element in the stipulated amount to be negated. At this point it is important to remember that in order for compensation to be awarded, the three elements for the establishment of 'damage' still need to be met, namely, there needs to be breach of contractual obligations, damage, and causation. 

Whilst at first glance Article 390 (2) may look to be a loophole favourable to the contractor, it may actually be a 2 edged sword, with the employer also being entitled to seek judicial recourse in terms of this Article. Thus the creditor (for example the employer) could and may also request that the court adjusts damages upwards to reflect the actual loss that has been suffered.

This is an interesting difference to the South African context whereby in terms of section 3 of the Conventional Penalties Act, the court is only entitled to reduce the penalty amount.

A court in the UAE is granted a wide discretionary power in terms of Article 390 (2), and it is important to note that the parties cannot contract out of and exclude this discretionary power.

Furthermore, it was confirmed in the Dubai Court of Cassation judgment number 138 of 1994 that the 'injured party' will not be obliged to prove the occurrence or the scope of damage suffered, and the party who makes an application for the agreed compensation to be varied, bears the burden of proof that such compensation does not reflect the actual loss suffered.

Conclusion

Some similarities between South African and United Arab Emirates legal systems can most certainly be drawn when it comes to the application of penalties, and the wide discretionary powers of intervention, afforded through legislation to the courts.

These powers may provide protection to a party that suffers from an unequal bargaining power, but to a party who values freedom of a contract, smacks of disregard to the right of the parties to exercise contractual freedom.

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.