In this article, Priya Agrawal discusses the calculation of damages in Engineering, Procurement and Construction contract in India.

Introduction

Engineering, Procurement and Construction contract, also known as EPC contract is a prominent form of contracting agreement in the construction and infrastructure industries, thermal power project, tunnelling, mining, etc. It is a contract wherein the contractor carries out the detailed engineering design of the project, procures all the necessary equipment and materials, and then constructs to deliver a functioning facility or assets to its clients.

In India, the construction industry has evolved from item rate packages to lumpsum contracts and then to EPC contracts over the years. It has resulted in a visible shift from owner-managed projects to projects in which the time and cost risks have been transferred to the contractor, along with the responsibility of designing, procurement of material and construction.

Obligations of parties to the contract

Section 37 of the Indian Contract Act, 1872 says that “the parties to a contract must either perform or offer to perform, their respective promises, unless such performance is dispensed with or excused under the provisions of this Act, or of any other law.”

Thus, section 37 imposes an obligation on the parties to perform their promises. Sometimes, the parties to a contract specify the time for its performance. Ordinarily, it is expected that either party will perform his obligation within the stipulated time. But, where the time is not mentioned, the parties must perform their promises within a reasonable time. Generally, time schedule in a construction contract is likely to be of the essence because construction is a commercial service.

Consequences of failure to discharge the contract by performance

A contract is not a property. It is only a promise supported by some consideration upon which either the remedy of specific performance or that of damages is available [Sunrise Associates v. Govt. of NCT of Delhi, (2006) 5 SC 603; AIR 2006 SC 1908]. The injured party to the contract may bring an action for damages.

Damages mean compensation in terms of money for the loss suffered by the injured party. The burden lies with the injured party to prove his loss.

In ordinary cases, the extent of liability is what may be foreseen by “the hypothetical reasonable man,” as arising naturally in the usual course of things. Since works and building contracts are undertaken only intending to earn profits, the party committing the breach would be liable for the contractor’s loss in terms of expected profits. The Supreme Court came to this conclusion in “A.T. Brij Paul Singh v. State of Gujarat” [AIR 1984 SC 1703; (1984) 4 SCC 59]. It was not disputed before the Supreme Court that wherein works contract the party entrusting the work commits a breach, the contractor would be entitled to claim damages for loss of profit which he expected from the project.

Computation of damages

The growth of the engineering and construction industry has increased the scope of disputes relating these rights and obligations. The number of arbitration cases in both public and private sectors has increased as almost all construction contracts these days contain an arbitration clause for the settlement of their disputes. The task of understanding one’s rights and obligations has become more challenging as The Arbitration & Conciliation Act, 1996 has brought about significant changes in the field of arbitration and also, the engineering & construction industry involves various other laws such as the Indian Contract Act, the Specific Relief Act, the Interest Act, etc.

The computation of actual damage suffered by a party due to the breach or underperformance of the terms of the contract by the other party is one of the major concerns in the resolution of any dispute or the adjudication process relating to the construction and engineering industry.

Sections 55 and 73 of the Indian Contract Act, 1872 do not lay down the manner and the mode in which the computation of the damages or compensation has to be done.

In M.N. Gangappa v. Atmakur Nagabhushanam Setty & Co. and Anr. [MANU/SC/0019/1972; AIR 1972 SC 696], the Supreme Court held that the method used for computation of damages would depend upon the facts and circumstances of each case. While calculating damages, the court must take into account only the strict legal obligations and not the expectations of one contractor that the other will do something that he has not assumed any legal obligation to do, however reasonable be the expectation.

Formulae for computation of damages

There is nothing in Indian law to show that law prohibits any of the formulae adopted in other countries or the same is inconsistent with the law prevailing in India. As the computation depends on circumstances and methods to compute damages, determination of the quantum thereof should be a matter which would fall for the decision of the court or the arbitrator. Different formulae can be applied in various circumstances and the question as to whether damages should be computed by taking recourse to one formula or the other formula, given the facts and circumstances of a particular case, would eminently fall within the domain of the court or the arbitrator.

In 2006, in the case of McDermott International Inc. v. Burn Standard Co. Ltd. [(2006) 11 SCC 181], the Supreme Court had the opportunity to discuss some of the formulae for computation of damages in detail, which may be used by the parties to calculate the amount of damages. In the case mentioned above, the Supreme Court recognized and dealt with the following formulae-

1. Hudson formula

This formula was propagated first in Hudson’s Building and Engineering Contracts, and can be stated in the following terms –

In Hudson formula, the head office overhead percentage is taken from the contract.

This formula is adapted for quantification of claims for overhead losses in India. In the case of “A.T Brij Paul Singh v. State of Gujarat “[AIR 1984 SC 1703; (1984) 4 SCC 59], the Hudson formula has been accepted by the Hon’ble Supreme Court for quantification of claims for overhead losses. On the basis of Hudson formula, the Claimants have claimed overhead losses up to 28^th January 2002 amounting to Rs. 1,88,15,960/-

The reasonability of the formula given by Hudson cannot be doubted, but as the overhead expenses considerably vary from contractor to contractor, it should be used with caution.

The Hudson formula has received judicial support in many cases. But, it adopts the head office overhead percentage from the contract as the factor for calculating the costs, and this may have little or no relation to the actual head office costs of the contractor. Thus it has been criticized principally.

Emden formula

This formula was propagated first in Emden’s Building Contracts and Practice, and may be stated in the following terms

This formula was laid down in the manual published by the Mechanical Contractors Association of America known as “Change Orders, Overtime, Productivity” commonly known as the Emden Formula.[1]

Under 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. It has also received judicial support in a number of cases[2] including Norwest Holst Construction Ltd. v. Cooperative Wholesale Society Ltd., decided on 17 February 1998, Beechwood Development Company (Scotland) Ltd. v. Mitchell, decided on 21 February 2001 and Harvey Shoplifters Ltd. v. Adi Ltd. decided on 6 March 2003.

Eichleay formula

The Eichleay formula was evolved in America and derives its name from a case heard by Armed Services Board of Contract Appeals, Eichleay Corp. It is applied in the following manner.

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 are first determined by comparing the value of work carried out for the duration of the contract for the project with the value of work performed 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 assigned 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, the equations presented above are not the only formulae to which the disputing parties can resort to for computation of the damages to which they are entitled. Time and again, the Courts in India, have reiterated that parties are at complete liberty to adopt any generally accepted formula to calculate the amount of damages. The only requirements are that there must be a cogent reason for applying the chosen method, and relevant facts and evidence must corroborate the amount which is claimed as damages. It is, therefore, generally accepted that different formulas can be applied in various circumstances. It shall be the discretion of the Court/the Arbitral tribunal to decide as to which method to be used for computing the damages. While determining the formula to be applied, regard is to be had to the facts and circumstances of a particular case. Thus, if an arbitrator decides a specific method to be used, he is not committing an error to make it a fit case for the interference of 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.

Liquidated damages in EPC contracts

Sometimes, the parties to a contract, at the time of making the contract, agree to the amount of compensation payable in the event of the breach of contract. This amount of compensation payable, which has been agreed beforehand, may be either liquidated damages or penalty. If the compensation payable is the genuine pre-estimate of the damages, it is known as liquidated damages. On the other hand, if the compensation is excessive and highly disproportionate to the likely loss or if it is fixed in terrorem with a view to discourage the breach of contract, it is known as the penalty.

Many times in EPC contracts, the parties mention the time of completion of the contract and determine the amount of compensation payable in the event of its non-completion or partial completion at the time of the making of the contract. Those are liquidated damages. For the liquidated damages clause to be enforceable, it is necessary that it must not be by way of penalty.

General principles of the Indian Contract Act

While computing the damages, the general principles set out in the Indian Contract Act,1872 must also be kept in mind. Section 73 of the Act states that when a contract has been broken, the party who suffers by such breach is entitled to receive compensation for any loss or damage caused to him by the party who has broken the contract. But such compensation shall be given only for the loss which arose naturally in the usual course of things, or those which could be contemplated by the parties to be likely to result because of the breach.

Such compensation is not be given for any remote and indirect loss or damage sustained by reason of the breach.

Conclusion

EPC contracts are a form of turnkey contracts wherein all the activities involved in a contract are the responsibility of the contractor. EPC contracts are popular mostly in construction, infrastructure industries which involve high costs. Thus, any breach of such contracts may cause substantial loss to the parties. This makes it imperative for the parties to compute damages meticulously. Courts and arbitral tribunals have recognized various formulae, including but not limited to, Hudson formula, Emden formula, and Eichleay formula for computation of damages in EPC contracts. However, parties can always resort to other methods of computing damages, and it shall be subject to the discretion of the court/arbitral tribunal as to which formula to be applied.

[1] Angerlehner Structural and Civil Engineering Co. and Ors. vs. The Municipal Corporation of Greater Mumbai and Ors. (31.03.2017 – BOMHC) : MANU/MH/0554/2017

[2] http://www.lawweb.in/2015/06/supreme-court-judgment-on-calculation.html