Spring 2008

THEritical Cpath

IN THIS ISSUE This edition of The Critical Path continues our emphasis on topics of interest in the national and international markets. The first article focuses on the different treat- Introduction—Page 1 ment of liquidated in some selected jurisdictions from around the world. The second article addresses an issue that is encountered frequently in most mar- Liquidated Damages and Penalty Clauses: A versus ketplaces, incorporation of documents by reference as part of the , although Comparison—Page 1 this article focuses on the U.S. market for this topic. Look for future editions of The Critical Path to expand on this topic in the international marketplace, as well as Incorporation of Terms and other topics with a broad scope that may be of interest to our readers. Conditions by Reference: The “Clear Reference” Test—Page 2 As always, we appreciate feed back and suggestions from readers of topics of inter- est, so please feel free to send an email with suggestions and ideas for future editions of The Critical Path. – The Editors

Liquidated Damages and Penalty Clauses: A Civil Law versus Common Law Comparison New York London In the United States, a liquidated damage clause is intended to estimate damages in HONG KONG the event of non-performance or . A liquidated damages clause CHICAGO Washington, D.C. will be enforced where the court finds that the harm caused by the breach is difficult BEIJING to estimate, but where the amount of liquidated damages is reasonable compensa- pARIS tion and not disproportionate to the actual or anticipated damage. The intent of liq- Los Angeles uidated damages is simply to measure damages that are hard to prove once incurred. San Francisco If the liquidated damages are disproportionate, they can, however, be declared a Philadelphia penalty. The clause is then void, and recovery will be limited to the actual damage Pittsburgh that results from the breach. Oakland munich The treatment of liquidated damage clauses varies slightly among different jurisdic- ABU DHABI tions within the United States, but generally the courts consider two elements to Princeton determine whether a liquidated damage clause is enforceable. The first is the uncer- N. VIRGINIA Wilmington tainty element; whether the harm caused by the breach is difficult to calculate. The birmingham second element is whether the amount of the liquidated damages is reasonable in DUBAI proportion to the actual or anticipated harm. If it is not, then it is a penalty, which Century City is against public policy, and therefore the clause is unenforceable. Richmond GREECE The American approach to liquidated damages can be illustrated by both the Uni- form Commercial Code and the Restatement 2d : r e e d s m i t h . c o m (continued on page 3, middle) | 1 | Incorporation of Terms and Conditions by Reference: The “Clear Reference” Test

Construction, supply and other ruled that the phrase “plans and specs” contracts frequently refer to other included more than merely the labor documents as part of the contract and material needed to perform the requirements, and often will incorpo- described work; it also included com- rate other documents “by reference” to mercial terms of the general contract not make them a part of the contract. This specifically referred to in the subcontract normally occurs because of the volume that governed the method of compen- of information, and also as a method sation for changed or extra work. In of simplifying the contract so that the this case, the commercial terms were obligations are clear among all the docu- incorporated by reference, even though ments. Most jurisdictions use a version not specifically referred to, because they of the “clear reference” test to determine were necessary to determine how to pay whether the referenced documents are for the work. Therefore, the incorpora- properly incorporated into the appli- tion satisfied the “clear reference” test. cable contract. A more recent case occurred in Florida. Most jurisdictions use A leading case on the issue of incorpora- In Kaye v. Macari Bldg. & Design, Inc. 967 tion by reference is Standard Bent Glass So. 2d 1112, (Fla. Dist Ct. App. 2007), a version of the “clear Corp. v. Glassrobots Oy, 333 F.3d 440 (3d the contract clearly incorporated plans reference” test to Cir. 2003). In that case, the court stated and specifications by reference. There the test as follows: “[i]ncorporation by was, however, an issue of whether an determine whether the reference is proper where the underly- , part of an AIA form, referenced documents ing contract makes clear reference to a was also incorporated by reference. The are properly incorporated separate document, the identity of the court determined that general notes on separate document may be ascertained, the plans and specifications made the into the applicable and incorporation of the document will form a part of the contract, and there- contract. not result in surprise or hardship.” Id. fore the arbitration clause was a part at 447. Frequently the incorporated of the contract, and the parties were document is attached, so the identity required to arbitrate. The reference to issue should not normally be a problem. the standard form on the general notes While it is important that there be no was sufficient to satisfy the “clear refer- surprise or hardship, a mere failure to ence” test. read the incorporated document does Occasionally this issue arises with not create surprise or hardship. Thus, respect to limitation of liability clauses, the crux of the test is the “clear refer- which may add an element of conspicu- ence” element. ousness to the test. Some jurisdictions Plans and specifications are frequently require that such clauses be in bold incorporated by reference, but disputes or capital letters to provide this added sometimes arise as to the extent of the element, although in most jurisdictions, incorporation of commercial terms. An “…limitation of liability clauses are example is Westinghouse Elec. Supply v. routinely enforced in contracts negoti- Fidelity and Deposit Co. of Maryland, 560 ated between sophisticated parties when F.2d 1109, (3rd Cir. 1977). In the West- the nature of the loss is commercial.” inghouse case, the issue was the intention Advanced Tubular Products, Inc. v. Solar of the parties when incorporating the Atmospheres, Inc., 2004 WL 540019, *4 phrase “plans and specs” of a general (E.D. Pa) Limitation of liability clauses contract into a subcontract. The court are “…common place in the commercial

| 2 | arena.” Id. at *6. They are an accepted applicable FIDIC form, or other stan- jurisdiction is important to know when way “…of allocating ‘unknown or dard form used in the industry.* Some drafting contracts and using the incor- undeterminable risk’… and are a fact of jurisdictions refer to the test as to poration technique. every-day business and commercial life.” whether the incorporated terms have – J. Frank McKenna and Id. at *6. been “fairly and reasonably” brought to Lisa P. Means the attention of the other party. See, e.g. This issue also arises in international Construction Industry Chitty on Contracts para. 12-015 (English contracts, and the rule frequently is Specialty Practice Group law). This seems similar to the “clear similar. It is not unusual in the inter- reference’ test used in many places in national marketplace to incorporate * See Critical Path Fall 2007 edition for a the United States, but it also points out “standard terms and conditions.” These discussion of the FIDIC General Conditions. that there could be subtle differences, can be terms and conditions from any and the specific test used in any given

Liquidated Damages and Penalty Clauses: A Civil Law versus Common Law Comparison (continued from page 1)

Restatement 2d Contracts § 356: and penalties, and allows for contractual In the UNICITRAL uniform rules relat- (1) Damages for breach by either party damages for failure to perform even if ing to liquidated damages and penalty 2 may be liquidated in the agreement but the intention is to penalize. clauses, this problem has been solved by simply referring to both as “contract only at an amount that is reasonable It is significantly more difficult to find a clauses for an agreed sum due upon in the light of the anticipated or actual consistent application of the concept of failure of performance.”4 According to loss caused by the breach and the dif- liquidated damages or other contractual the UNICITRAL rules, an agreement ficulties of proof of loss. A term fixing “penalties” in civil code countries in between parties of a contract to pay a unreasonably large liquidated damages the international marketplace. The UN certain sum in the event of non-perfor- is unenforceable on grounds of public Convention on Contracts for the Inter- mance is generally allowed, whether as a policy as a penalty. national Sale of Goods (“CISG”), which penalty or compensation. However, the has generally been an important tool in UCC § 2-718: amount can be reduced by the courts if developing a more uniform international it is “substantially disproportionate to (1) Damages for breach by either party sales law, regulates neither liquidated the actual loss.”5 may be liquidated in the agreement but damages nor penalty clauses. In fact, only at an amount which is reasonable the framers of the CISG agreed to leave in the light of the anticipated or actual Liquidated Damages and Penalty these clauses out of the convention, Clauses in Civil Codes harm caused by the breach, the diffi- in favor of regulation by domestic law, culties of proof of loss and the incon- because of widely divergent approaches In civil law countries, the attitude venience or nonfeasibility of otherwise in different legal systems.3 The enforce- toward contractual penalties is quite dif- obtaining an . A term ability of liquidated damage and penalty ferent from the common law approach. fixing unreasonably large liquidated clauses thereby depends on domestic The Napoleonic Code, upon which damages is void as a penalty. law. most civil codes are based, allowed for penalties to encourage performance of Most other common law countries One dilemma in the comparison contractual obligations. (This is the such as England, Australia, Ireland and between common and civil law is the precise rationale that is rejected in the Canada have similar rules with regard confusion of terminology with regard United States.) In recent years, however, to liquidated damages, and do not allow to liquidated damages. This confu- there has been a widespread trend in for liquidated damages that are used as sion arises because in some countries, 1 civil law countries toward narrowing the a penalty. One exception to the rule is whether under civil code or doctrine or scope of such penalties, and allowing India, where the Contracts Act makes no case law, both concepts are recognized distinction between liquidated damages and the terms are used interchangeably. (continued on page 4)

| 3 | Liquidated Damages and Penalty Clauses: A Civil Law versus Common Law Comparison (continued from page 3)

courts to reduce the amount if they find stances it was concluded, with emphasis it excessive. on the relative social and economic position of the parties; whether it was a Traditionally, in civil code countries, no standard-form contract; and whether the distinction was made between liquidated breach was in good or bad faith.9 damages clauses and penalty clauses.6 Recently, a more common approach Many, but not all, civil codes seem to seems to distinguish between liqui- have followed the precedent of the dated damages clauses that are used to Resolution to allow courts to reduce an estimate damages in case of non-perfor- excessive penalty, as demonstrated by mance, based on the concept that there the following examples: has been an actual harm to the plaintiff, France: Articles 1226 to 1233 of La and penalty clauses that are used to Code Civil regulates “la clause penale” establish a penalty to be paid in case (penalty clause), and article 1152 regu- of non-performance with the intent to lates “dommages-interets” (liquidated encourage performance. The latter does damages). The former may be reduced not require proof of any real damage. by a judge if part of the main contract Although penalty clauses Penalty clauses in civil law jurisdic- obligation has been performed and if tions can be described as the kind of it is “manifestly excessive.” Liquidated have been generally liquidated damages that would not be damages may also be adjusted if “obvi- enforceable in civil law enforceable in the United States because ously excessive or ridiculously low.”10 of public policy prohibiting liquidated Italy: Both concepts, “clausola penale” countries, they can now damages designed to punish the non- (penalty clause) and “liquidazione be mitigated by the court performer. Although penalty clauses convenzionale del danno” (liquidated have been generally enforceable in civil in most jurisdictions. damages), exist in doctrine, but not in law countries, they can now be miti- the Civil Code.11 Penalties are gener- gated by the court in most jurisdictions.7 ally enforceable but can be mitigated The Council of Europe issued a “Resolu- if “manifestly excessive” or if part of tion on Penalty Clauses” in 1971, with the main contract obligation has been the aim of recommending a uniform performed.12 13 application of penalty clauses for the member states to use. The resolution Spain: Article 1154 of the Codigo allows penalty clauses, but the penalty Civil regulates penalty clauses (Clausula amount may be reduced by the courts if Penal), which can be reduced by a judge they are manifestly excessive, or if part if part of the main contract obligation of the main contractual obligation of the has been performed. There is no provi- contract has been performed.8 sion regarding mitigation of the penalty because of excessiveness, which makes The explanatory memorandum to the Spain one of the few countries that has Resolution provides a list of factors in not amended its Civil Code to allow a determining whether a penalty is mani- reduction of a penalty amount. festly excessive. They include the com- parison of the pre-estimated damages to Germany: There is a distinction the actual harm; the legitimate interest between liquidated damages (Schaden- of the parties, including non- pecuniary spauschale) and contractual penalties interests of the promisee; what category (Vertragsstrafe) in the German Civil of contract it is and under what circum- Code, and both are allowed according

| 4 | to article 340 and 341 of the BGB. The It is difficult to find any uniform ap- Mitigation may be ordered by the judge difference between them is that the latter plication of liquidated damages/penalty even if neither of the parties has asked can be mitigated if “disproportionate or clauses in case law of the various Euro- for it.23 excessively high.”14 pean countries. In most countries, the Portugal: The Supreme Court upheld courts never evaluate the intent behind Netherlands/Switzerland: Both of these a penalty clause in a car lease contract, the penalty. Whether it is enforceable countries have rules similar to Germany, since the penalty was in proportion to depends solely on whether it is exces- except that a penalty may be mitigated the risk of a breach of the contract and sive in its amount. Some countries in the Netherlands if “manifestly exces- loss of the value of the car.24 have, however, taken a more restrictive sive,” and in Switzerland if “excessive.”15 approach, and also examine the rela- Conclusion Belgium: Penalty clauses are permitted, tionship between the penalty/liquidated but the amount can be mitigated if it damages and the actual loss suffered by Even though the development of liq- “obviously exceeds the actual damage,” the plaintiff. This approach is similar to uidated damages clauses seems to be and if part of the main contract obliga- the common law approach to liquidated moving toward a more uniform ap- tion has been performed.16 damages. proach, a contract clause penalizing one party for non-performance or breach of Scandinavia: The laws of Denmark, Examples of a more Anglo-American contract will still be met with a different Finland, Norway and Sweden allow approach: response in common law versus civil law either the voiding or reformation of a Denmark: The Supreme Court struck jurisdictions. In a common law jurisdic- penalty clause that is deemed to be “un- down a penalty clause because of a dis- tion, such a clause will not be enforced reasonable.” Swedish law specifically proportionate penalty in relation to the if it is not reasonable in proportion to provides for an evaluation of the rela- contract price. The penalty in question the actual or anticipated damage, and tive bargaining power of the parties in was four to six times the contract price. if it is designed to penalize the breach- making this determination. The Swed- The court also found that the plaintiff ing party. In civil law jurisdictions, the ish Commercial Code Section 36(2) had not proved that he had actually suf- assumption is that a penalty clause is provides that “particular ” fered the corresponding loss.20 enforceable, but may be reduced if it shall be given to protecting the party “in reaches a certain level of excessiveness. a subordinate position in the contractual Belgium: The Court established that In a comparison of the elements of the relationship.”17 the amount in a penalty clause can be common law approach, the first step of declared unenforceable if the penalty deciding the difficulty of estimations of Other civil law countries outside Europe amount “obviously exceeds actual dam- the actual damage is generally absent in have adopted a similar approach, such age.” However, the clause would not civil law jurisdictions, except as one of as: be voided, but the amount would be many factors weighing in to the deter- China: Penalty clauses in contracts are reduced.21 mination of “excessiveness.” Since a permitted, according to article 114 of clause that is purely a penalty can be Examples of a more traditional civil law the Chinese Contract Law. The amount enforced in civil law jurisdictions, there approach: can be increased or reduced by the is no need to decide whether the intent People’s Court or in arbitration if “exces- Spain: A penalty clause was found to be behind having a liquidated damage sively higher than loss.”18 unenforceable, since there was no con- clause is based on a real difficulty of nection to the main contractual obliga- estimation foreseen at the execution of Russia: The New Civil Code from 1994 tion. The court did not discuss whether the contract. The reasonableness test allows for both liquidated damages and the amount was excessive or not.22 of common law jurisdictions can be contractual penalties in contracts. Both compared to the civil law test of whether can be reduced by the court if obviously Italy: The Court found that a penalty 19 the penalty amount is “manifestly exces- disproportionate to the actual loss. clause can be reduced if manifestly sive” or “excessive,” depending on the excessive or if the main contractual Application in the Courts of Civil Law respective code. Most civil law systems obligation has been partially performed. Jurisdictions (continued on page 6)

| 5 | Commissioning the Way to Building Success (continued from page 1) Contributor To This Issue will not assess the reasonableness of the penalty amount solely in relation to the actual J. Frank McKenna Pittsburgh harm, but will make an assessment based on a number of different factors. This leaves +1 412 288 4208 significantly more discretion to the courts to determine on a case-by-case basis what is [email protected] permissible, and what may be “excessive” or “manifestly excessive”; but the Resolution on Penalty Clauses adopted by the Council of Europe provides guidelines for use in Jay has practiced law since 1973 in the area of complex exercising this discretion. corporate, commercial, and construction – J. Frank McKenna litigation and arbitration. He has extensive trial ______experience in state and federal courts in the 1 See, for example, one of the leading cases on penalties, Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co United States and in international arbitrations Ltd [1915] AC 79, 86-87, where the House of Lords established the principles on how to determine whether a administered by many different arbitration damage clause actually is a penalty and thereby unenforceable. This case was cited by the High Court of Aus- agencies. Jay’s area of practice includes tralia in Ringrow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71, section 12, and by the Supreme Court of Ireland manufacturing, engineering, technology and in O’Donnell v Truck and Machinery Sales Limited 1998 4 IR 191. The Supreme Court of Canada has adapted a similar approach in Elsley v. J.G. Collins Ins Agencies, [1978] 2 S.C.R. 916, 946, and does not allow for any recov- intellectual property issues largely in the steel, ery of an amount exceeding the actual damage. metals and energy industries in both national and international projects. 2 Indian Contracts Act, Section 74 3 Marcus S Jacobs & Yanming Huang, “An Arbitrator’s Power and Duties Under Art 114 of Chinese Contract Law In Awarding Damages In China In Respect of A Dispute Under Contract Governed by CISG,” Mealey’s Interna- tional Arbitration Report (May 2005, Volume 28, Issue #5) at 3.2 To Receive Future Issues of 4 Uniform Rules on Contract Clauses for an Agreed Sum Due upon Failure of Performance and Draft United Na- tions Convention on Contract Clauses for an Agreed Sum Due upon Failure of Performance. Official Records of The Critical Path by Email… the General Assembly, Thirty-eighth Session, Supplement No 17 (A/38/17, annexes 1 and 2). 5 Id. article 9 …contact Rachel Abbott at 412.288.3002 or [email protected]. She will be 6 Antonio Pinto Monteiro, “Clause Penale/Penalty Clause/ Verstragsstrafe,” European Review Private Law happy to assist in changing your contact 1:149-155, 2001 (Kluwer Law International.) at 149 preference to electronic distribution. 7 Scottish Law Commission, Penalty Clauses, (Scot Law Corn No 171) 1999, at 2-3 8 Resolution 78(3) of the Committee of Ministers of the Council of Europe; Relating to Penal Clauses in Civil Law 9 Larry A. DiMatteo, “A Theory of Efficient Penalty: Eliminating the Law of Liquidated Damages 38,”Am. Bus. L.J. 633, at 653 10 Article 1152 of Code Civil 11 Article l382 in Codice Civile regulates penalty clauses. 12 Id. article 1184 13 The Portuguese Codigo Civil takes an identical approach in its article 812. 14 Burgerliches Gesetzbuch, (BGB) Article 343 BGB. 15 New Civil Code, art 94, Livre 6 and Code de Obligation Suisse art 163,3 16 Code Civil Article 1231 17 Supra note 9, at 654-655 18 Supra note 2, at 6.1 19 Ikko Yoshida, “Comparison on rewarding interest on damages in Scotland, England, Japan and Russia,” Journal of International Arbitration 17(2): 41-72, 2000. (Kluwer Law International) At 66 (see Civil Code article The Critical Path is published and distributed by 330-331) Reed Smith for the genreal information of its clients, friends and newsletter recipients. The opinions 20 The Danish Hojesteret 15 June 2004 (U.2004.4200H). From “Recent Case Law,” European Review of Private Law expressed in The Critical Path are those of the 2-2005 [225-263] (Kluwer Law International) at 234 section 4.1 individual authors and not necessarily those of Reed Smith. The contents of The Critical Path are 21 The Belgian Hof van Cassatie/Cour de Cassation 16 December 2002 (nr. C.00.0176N). From “Recent Case not designed or intended to be, nor should they be Law,” European Review of Private Law 2-2003 [235-263] (Kluwer Law International) at 257 section 4.5 considered or used as, the sole source of analyzing or resolving any legal problems. If you have, or think 22 The Spanish Tribunal Supremo 25 October 2004 [RJ 2004/6403]. From “Recent Case Law,” European Review of you may have, such a legal problem or issue related Private Law 2-2005 [225-263] (Kluwer Law International) at 234 section 4.1 to any of the matters discussed in The Critical Path, consult legal counsel. 23 The Italian Corte di Cassazione, Sez. 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