The Calculation of Damages in Engineering, Procurement & Construction (EPC) Contracts in India
The engineering & construction industry, especially that in India, is dynamic and highly volatile, making it susceptible to tremendous amounts of litigation and other forms of alternative dispute resolution. The rapid and substantial growth in the magnitude of this industry has resulted in the increased need for information about the rights and obligations of the various players involved in the execution of a particular work of construction. It has become essential that proper attention is given to assert one’s rights and discharge one’s obligations as laid down by the law and also by a correct understanding of the meaning and interpretation of the terms of the contract governing such relationships, as otherwise the basis of estimates and calculations made will become infructuous.
With the growth of the engineering & construction industry, the scope of disputes relating to these rights and obligations has also increased. As almost all construction contracts these days contain an arbitration clause for the settlement of disputes arising therefrom, the number of arbitration cases, both in the public as well as private sectors, has consequently increased manifold. The enactment of the Arbitration & Conciliation Act, 1996 has brought about several significant changes in the field of arbitration. This, coupled with the fact that the engineering & construction industry involves various other laws, including the Indian Contract Act, the Specific Relief Act, the Interest Act, etc. has made the task of understanding one’s rights and obligations all the more challenging.
One of the major concerns in any dispute resolution/adjudication process in relation to the engineering & construction industry is regards the computation of actual damages suffered by a party as a result of the breach/under-performance of the other party of the terms and conditions of the contract. Disputing parties often find it very difficult to mathematically calculate the damages that they feel they are entitled to. More often than not, in order to tackle this, parties claim unrealistic amounts in damages, and are finally awarded miniscule percentages of the amounts claimed. Although there is no law that precludes a party from claiming astronomical amounts in damages, the law does stipulate that the quantification of a claim for damages is a matter of proof. In other words, the amount claimed in damages is required to have been arrived at by some generally accepted mathematical formula and duly supported by documents/evidence.
Neither Section 55 nor Section 73 of the Indian Contract Act nor any other law lays down the mode and manner as to how and in what manner the computation of damages or compensation has to be made. Moreover, there is nothing in Indian law to show that any of the formulae adopted in other countries is prohibited in law or the same is inconsistent with the law prevailing in India. So, how then, should a party calculate the amount of damages/compensation that it feels it is entitled to? The Supreme Court of India had, to a certain extent, answered this question as early as 1972 when it had held that the method used for computation of damages will depend upon the facts and circumstances of each case. In the assessment of damages, the court must consider only strict legal obligations, and not the expectations, however reasonable, of one contractor that the other will do something that he has assumed no legal obligation to do.
More recently in 2004 the Supreme Court further clarified the issue of computation of damages by stating that it is not unusual for the contractors to claim loss of profit arising out of diminution in turnover on account of delay in the matter of completion of the work. What should be established in such a situation is that had the contractor received the amount due under the contract, it could have utilized the same for some other business in which it could have earned profit. Unless such a plea is raised and established, claim for loss of profits could not have been granted. Although this judgment unambiguously recognizes the right of a party to claim damages for loss of profit, it does not really provide a formula for calculating the exact amount of damages.
Finally, in 2006 the Supreme Court in the case of McDermott International Inc. had the opportunity to discuss in detail some of the formulae that may be used by parties to calculate the amount of damages. In the said judgment, the Supreme Court broadly recognized and dealt with the following formulae –
1. Hudson Formula This formula was first propagated in Hudson’s Building and Engineering Contracts, and is stated in the following terms –
Contract Head Office overhead profit percentage x Contract sum_ x Period of delay Contract period
As can be seen, in the Hudson formula, the head office overhead percentage is taken from the contract. Although the Hudson formula has received judicial support in many cases, it has been criticized principally because it adopts the head office overhead percentage from the contract as the factor for calculating the costs, and this may bear little or no relation to the actual head office costs of the contractor.
2. Emden Formula This formula was first propagated in Emden’s Building Contracts and Practice, and is stated in the following terms –
Head Office overhead & profit x Contract sum x Period of delay 100 Contract period
Using the Emden formula, the head office overhead percentage is arrived at by dividing the total overhead cost and profit of the contractor's organization as a whole by the total turnover. This formula has the advantage of using the contractors actual head office and profit percentage rather than those contained in the contract. This formula has been widely applied and has received judicial support in a number of cases.
3. Eichleay Formula This formula was evolved in America and derives its name from a case heard by the Armed Services Board of Contract Appeals, Eichleay Corporation. It is applied in the following manner –
Step 1: Contract billings x Total overhead for = Overhead allocable to the Total billings for contract period contract contract period
Step 2: Allocable overhead = Delay overhead rate Total days of contract
Step 3: Daily contract overhead rate x Number of days of delay = Amount of unabsorbed overhead
This formula is used where it is not possible to prove loss of opportunity and the claim is based on actual cost. It can be seen from the formula that the total head office overheads during the contract period is first determined by comparing the value of work carried out in the contract period for the project with the value of work carried out by the contractor as a whole for the contract period. A share of head office overheads for the contractor is allocated in the same ratio and expressed as a lump sum to the particular contract. The amount of head office overhead allocated to the particular contract is then expressed as a weekly amount by dividing it by the contract period. The period of delay is then multiplied by the weekly amount to give the total sum claimed.
The above are the formulae that were discussed in detail by the Supreme Court in the case of McDermott International Inc. However, these are by no means the only formulae that are available to disputing parties while computing the damages that they may be entitled to. Time and again, the Courts in India, have reiterated that parties are at complete liberty to adopt any generally accepted formula in order to calculate the amount of damages. The only requirements are that there must be a cogent reason for applying the chosen formula, and the amount claimed in damages must be supported by relevant documents/evidence.
It is, therefore, generally accepted that different formulas can be applied in different circumstances and the question as to whether damages should be computed by taking recourse to one or the other formula, having regard to the facts and circumstances of a particular case, would be the prerogative of the Arbitrator. If an Arbitrator, therefore, decides to apply one particular formula in assessing the amount of damages, he cannot be said to have committed an error that would warrant the interference by a Court. In other words, if an Arbitrator prefers one formula as against another for the computation of damages, the same cannot be challenged in a Court.
Once a Final Arbitral Award is passed, the same becomes final and binding between the parties. Section 34 of the Arbitration & Conciliation Act, 1996 provides certain contingencies in which a Final Arbitral Award can be set aside by a Court. However, the Courts have, time and again, interpreted and construed this Section in a very narrow manner, effectively leaving very little room for parties to challenge a Final Arbitral Award in Court. The Courts are always reluctant to interfere with a Final Arbitral Award because the Arbitrator is a judge chosen by the parties and, therefore, his decision must be respected. Nonetheless, a Final Arbitral Award may be set aside by the Court if the same is totally perverse or is based on a wrong proposition of law. A Court may interfere if the award is based upon a proposition of law which is unsound in law and which erroneous proposition of law vitiates the decision of the Arbitrator. The error of law must appear from the Award itself. It is generally accepted that a Final Arbitral Award can be set aside by a Court if the Arbitrator has mis-conducted the proceedings. Misconduct, in this case, refers to legal misconduct which arises if the Arbitrator on the face of the award arrives at a decision ignoring material documents.
As regards the computation and/or award of damages, an Arbitral Award may be set aside by a Court if – · a valuation report has not been relied upon in support of the claim for damages; · an expert valuer has not been examined to support the claim for damages; · damages is awarded based on the evidence of laypersons; etc.
The above is only an illustrative list, and there may be other reasons why an award for damages may be set aside by a Court.
******************************** # Section 55 Contract Act, 1872 – Effect of failure to perform at fixed time, in contract in which time is essential. # ection 73 Contract Act, 1872 – Compensation for loss or damage caused by breach of contract. # M.N. Gangappa vs. Atmakur Nagabhushanam Setty & Co. and Anr.; AIR 1972 SC 696 # Bharat Coking Coal Ltd. vs. L.K. Ahuja; (2004) 5 SCC 109 # McDermott International Inc. vs. Burn Standard Co. Ltd. and Ors.; (2006) 11 SCC 181 # State of U.P. vs. Allied Constructions; (2003) 7 SCC 396 # Trustees of the Port of Madras vs. Engineering Constructions Corporation Ltd.; AIR 1995 SC 2423 # K.P. Poulose vs. State of Kerala and Anr.; AIR 1975 SC 1259 # Union of India and Ors. Vs. Banwari Lal and Sons (P) Ltd.; AIR 2004 SC 1983
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