The Saudi Civil Transactions Law (the Saudi Civil Code) entered into force on 16 December 2023 and applies retrospectively with a few exceptions (see our previous blog for more details on the application of Saudi Civil Code). A key area that will benefit from the greater legal certainty brought by the Saudi Civil Code is the law on liquidated damages.
Liquidated damages are commonly used in construction contracts to compensate the employer for the contractor’s failure to meet contractual completion dates.
Prior to the entry into force of the Saudi Civil Code, the enforceability of liquidated damages clauses under Shari’a rules was uncertain. Saudi court decisions that upheld liquidated damages often cited a resolution of the International Islamic Fiqh Academy (IIFA) of the Organization of the Islamic Conference which stipulated certain conditions for these agreements to be Shari’a-compliant (IFAI Resolution No 109 (3/12), 12th session, 23-28 September 2000). Notwithstanding this approach, Saudi courts were not always consistent in how they treated liquidated damages clauses, especially as regards the standard for adjustment of liquidated damages and the party that has the burden of proof. The Saudi Civil Code brings much needed certainty on the relevant standards that will now determine the enforceability of liquidated damages clauses governed by Saudi law.
New regime for liquidated damages
In principle, damages for breach of contract are assessed by the judge. However, the Saudi Civil Code permits the parties to contractually pre-determine the amount of compensation payable for a specific breach. Damages fixed by agreement in this manner are known in many civil-law jurisdictions in the Middle East as “agreed damages” (al-ta'weed al-ittifaqi), “liquidated damages” and “penalty clauses” (al-sharṭ al-jazāʼī), inspired by the French term clause pénale. Notwithstanding the reference to a “penalty”, the main purpose of these provisions is compensatory. The Saudi Civil Code uses the term “agreed damages”.
The Saudi Civil Code upholds party autonomy and recognises the validity of liquidated damages clauses in principle. Article 178 permits parties to agree the quantum of damages before a breach has occurred. The only obligations that cannot be protected by liquidated damages are payment obligations. This is because liquidated damages for the late payment of money would constitute interest, which remains forbidden under the Saudi Civil Code and Shari’a law as applied in the Kingdom (non-payment is ordinarily remedied though an order for specific performance).
Under Article 179, a court or tribunal may revisit the liquidated damages clause on the application of a party—it cannot do so on its own motion. The debtor may ask the court not to enforce the liquidated damages clause (and not to award any damages for breach of the protected obligation) if it shows that, notwithstanding the breach, the creditor has not suffered any actual loss. Alternatively, the debtor may ask the court to reduce the liquidated damages amount if it shows that (i) the obligation was partially performed, and/or (ii) the amount is exaggerated or “disproportionate” when compared to the actual loss. In neighbouring jurisdictions with similar provisions, to prove that the liquidated damages are exaggerated, the debtor must show that they significantly exceed the creditor’s actual loss. Unlike certain jurisdictions in the region (such as the UAE), the Saudi Civil Code does not allow the courts to adjust liquidated damages if they are not “equal” to the creditor’s actual loss. It would therefore not suffice to prove that the creditor’s actual loss is “less” than the liquidated damages amount—the difference between the two must be substantial. Unless that is proven, the court must uphold the liquidated damages amount in full.
Moreover, Article 179 allows the creditor to request more than the amount fixed in the contract to match its actual loss. However, the scope for an upward adjustment of liquidated damages is very limited—the creditor must show that the debtor’s breach was wilful or grossly negligent. This is consistent with Article 173 of the Saudi Civil Code which forbids limitations of liability for wilful breach or gross negligence.
These rules are mandatory which means that any agreement that contradicts Article 179 is void with the consequence that the court may award general damages in accordance with the default rules of contractual liability.
A liquidated damages clause therefore has four main effects under the Saudi Civil Code:
- it creates a rebuttable presumption that breaching an obligation protected by liquidated damages will cause harm to the creditor;
- it creates a rebuttable presumption that the amount of damages fixed in the contract reflects the actual harm that the creditor will suffer as a result of the breach;
- it shifts the burden of proof to the debtor to disprove the rebuttable presumptions above if it seeks a downward adjustment of liquidated damages; and
- it sets a cap on the debtor’s liability for breaching a protected obligation which, like any limitation of liability, is valid except in cases of wilful breach and/or gross negligence.
While some of the rules above overlap with how Saudi courts treated liquidated damages clauses under Shari’a, there are two main areas where the Saudi Civil Code has brought greater certainty. First, the threshold for judicial intervention has been made clearer—the judge can only adjust the amount of damages fixed in the contract downwards if the debtor shows that (i) the creditor has not suffered any actual loss; (ii) the agreed damages are exaggerated or disproportionate compared to the creditor’s actual loss, and/or (iii) the protected obligation has been partially performed; whereas the only instance where the judge may adjust the agreed damages upwards is when the creditor proves that its actual loss exceeds the agreed damages due to the debtor’s wilful breach or gross negligence. Second, it is now clearer who has the burden of proof, as this is an area where judicial applications were mixed under the old law. The Saudi Civil Code places the burden of proof on the party arguing that the liquidated damages clause should not be upheld. The burden will rest with the debtor if it seeks a downward adjustment or the setting aside of liquidated damages entirely. This is contrary to the default rule on damages that requires the creditor to establish all elements of liability including the occurrence and quantum of its loss whereas the burden of proof is on the creditor if it seeks an upward adjustment of the agreed damages.
Lastly, as it stands today, Saudi law distinguishes between liquidated damages (under the Saudi Civil Code) and penalties that may apply in government contracts for the procurement of public utilities and services (under the 2019 Government Tenders and Procurement Law (GTPL)):
- Liquidated damages apply to various types of contract breaches and are primarily compensatory in nature. They may therefore be adjusted by the courts based on evidence of partial performance and/or actual loss (within the parameters described above).
- Financial penalties (or, fines) in government contracts seek to compel the timely and proper performance of contracts involving government bodies to protect the public interest. They apply to defined breaches and are subject to specific caps (unless the government body obtains the prior approval of the Minister of Finance to increase the applicable cap before bidders submit their proposals and the increase is brought to their attention). For example, the GTPL provides that delay penalties are capped at 6% of the contract value for supply contracts and 20% for all other contracts. In contracts for public works, the 20% cap may be calculated by reference to the value of the delayed works only (rather than the entire contract value) if certain conditions are met following provisional acceptance. Penalties may also be imposed on a broader range of breaches in continuing service agreements up to 20% of the contract value.
Notably, the defences available to the private contracting party to avoid penalties under government contracts are defined under the GTPL and its Executive Regulations: namely, if (1) the contractor obtains an extension of time as a result of a variation, (2) the annual appropriations for the project are insufficient to fund the completion of the works by the agreed schedule, (3) the delay is attributable to the government body or unforeseen circumstances, (4) the delay is attributable to causes beyond the contractor’s control, and/or (5) the government orders suspension of the works, in whole or in part, for reasons not attributable to the private contracting party.
Conclusion
The Saudi Civil Code has clarified the limits on party autonomy with respect to liquidated damages clauses and brings much needed certainty to those doing business in the Kingdom. It has also aligned the law on liquidated damages in Saudi Arabia with those of many neighbouring jurisdictions. It is yet to be seen how the Saudi courts will apply this new regime in practice.
