The Application of Penalties (but which end of the donkey gets the carrot?)

South Africa and Namibia have a unique piece of legislation, the Conventional Penalties Act, 15 of 1962. Although I cannot claim to have researched legal jurisdictions everywhere in the world I have not come across a similar piece of legislation which provides for the enforcement of penalty stipulations. In the majority of jurisdictions and particularly in Africa whose countries tend to have retained the legal system of the original colonizers we typically see a situation where the common law, notwithstanding agreement between the parties as reflected in a contract, will set aside a true penalty provision as being contrary to public policy and therefore unenforceable. In these jurisdictions the Employer will usually insist upon what is referred to as liquidated damages or sometimes liquidated and ascertained damages (LD’s or LAD’s). LD’s are required to be a reasonable estimate of the actual loss which would be suffered by the Employer in the event that the Contractor, as a consequence of its own default, in other words for reasons for which it is not entitled to an extension of time, completes the work late. This necessarily requires a fixed date to be established against which the LD’s can be applied. The estimate is obviously made at the time of entering into the contract and subject to the estimate meeting the aforementioned requirements the LD is then deductable by way of setoff from amounts due to the Contractor.

In 1962 South Africa promulgated the Conventional Penalties Act. Although its application clearly is appropriate for the construction industry, it is believed that this was in fact an early piece of consumer legislation to protect a consumer from forfeiture of goods towards the end of an HP agreement when the consumer had made payment of the majority of the payments but defaulted towards the end of the period and was then liable to have the goods confiscated or forfeited. The Act makes it clear that it also provides for the enforcement of such forfeiture clauses.

This piece of legislation appears to provide a loophole to Contractors who are trying to escape the consequence of the application of a penalty through the provisions of Section 3 “reduction of excessive penalty”, which provides:

         “If upon the hearing of a claim for a penalty, it appears to the Court that such
penalty is out of proportion to the prejudice suffered … the Court may reduce
the penalty to such extent as it may consider equitable in the circumstances”.

Significantly the wording of this section of the Act does not compare the damages suffered by the Employer as a benchmark against which the penalty might be reduced, but instead refers to “prejudice”, a much wider term in law and one which would embrace, consequently, far more issues than would simply be covered if the Employer had to demonstrate the actual loss/damages it had suffered. Furthermore, if a Contractor wishes to rely upon Section 3 it bears the onus to demonstrate that the penalty is indeed out of proportion to the Employers prejudice and that onus is going to be very difficult to discharge. In a reported judgment Steinberg v Lazard 2006 (5) SA 42 (SCA) the Court confirmed that the debtor would bear the onus of proving that the penalty was out of proportion to the prejudice suffered by the creditor and that the creditor was neither required to allege nor prove such prejudice.

Given that the Supreme Court of Appeal has determined that the Employer would not need to either allege or prove any prejudice increases the burden on the Contractor dramatically.

Section 3 of the Conventional Penalties Act was also the subject of debate in Western Credit Bank Limited v Kajee 1967 (4) SA 386 (N) which case confirmed that what Section 3 contemplates is that the penalty is to be reduced if it has no relation to the prejudice, if it is markedly, not infinitesimally, beyond the prejudice, if the excess is such that it would be unfair to the debtor not to reduce the penalty, but otherwise, if the amount of the penalty approximates that of the prejudice, the penalty should be awarded.

       “Prejudice is a wider connotation than damages. It may include impairment
of reputation or personal dignity and possibly cover any substantial inconvenience.
If the plaintiff contends for any prejudice in a wider sense than damages suffered,
then it will be for it to produce evidence to establish this”.

And finally to drive the nail into the coffin the question of what the meaning of “out of proportion to the prejudice suffered” was debated in Van Staden v Central South African Lands and Mines 1969 (4) SA 349 (W) where the Court determined that in interpreting this section of the Act:

       “Everything that can reasonably be considered to harm or hurt, or be calculated to
harm or hurt a creditor in his property, his person, his reputation, his work, his
activities, his convenience, his mind, or in any way whatever interferes with his
rightful interests as a result of the Act or omission of the debtor, must, if brought
to the notice of the Court, be taken into account by the Court in deciding whether
the penalty is, in terms of Section 3 of the Conventional Penalties Act, 15 of 1962,
out of proportion to the prejudice suffered by the creditor”.

It is perhaps for these reasons, namely the difficulty of establishing that the penalty is out of proportion to the prejudice suffered, that there appears to be only one reported judgement involving a construction contract where a Contractor has successfully applied to Court for the reduction of a penalty. (Afriscan Construction (Pty) Ltd v Umkhanyakude District Municipality & another [2005] JOL 14365 (D)

There are numerous reported judgments dealing with penalties which arise in contracts other than construction contracts where the Court has come to the assistance of the one party but the fact of only one reported judgment in respect of a construction contract emphasizes the extreme difficulty a Contractor will face. It is also however possible that since the majority of construction disputes are resolved either by way of alternative dispute resolution processes or by way of arbitration, which is by its very nature private and does not give rise to publication of the award in the general public domain, that Arbitrators may have reduced a penalty through the application of Section 3 of the Conventional Penalties Act. As to whether an Arbitrator is indeed empowered to do so given that Section 3 of the Conventional Penalties Act refers only to a “Court”, is a further question which may have to be decided in the future.

Apart from all of the above legal difficulties in regard to Section 3 of the Act, one must really question the merits of penalties in the first instance. There is no doubt that Contractors work best for an incentive and are likely to do everything possible to recover the losses associated with the potential application of a penalty. Furthermore the Employer can never be certain that in accepting a Contractor’s price, where the Contractor believes it may be at risk for the application of a penalty because of a tight construction period, that the Contractor has not in fact built into the contract price some element of the penalty. A case in point might well be the King Shaka and Dube Trade Port contracts currently under construction as part of the 2010 world cup infrastructure. The contract was let at R6.8 billion. Penalties of R750 000.00 per day were applicable to the airport if it was not completed by the stipulated date. Thus is the Contractor considered it might overrun the stipulated dates by, say, six weeks, all it needed to do was to build in approximately R30 million to the contract price of R6.8 billion and it would then be fully protected against the application of up to six weeks of penalties. [I am not of course suggesting that the Group 5 Consortium did this!]. If this did in fact happen and the Contractor overran then the Employer would simply get his own money back at the end of the day and the Contractor would suffer no additional loss other than the direct time related costs of being on the site for longer. A far better mechanism would have been to hold out the carrot of a R30 million bonus if completion was achieved on time. I have no doubt that Contractors would strive to achieve a bonus whereas they may well be in a position to protect themselves against the application of a penalty. Unfortunately in the construction industry we believe we are applying the carrot and the stick approach but frequently all we are doing is beating the donkey over the head with the stick whilst burying the carrot in its backside!

If Employers really wish to achieve timeous completion then they must a) ensure the constructions periods are realistic; b) ensure that the Contractor with whom they contract is adequately resourced and has the appropriate expertise; c) create interim milestones against which performance bonuses are linked. Regrettably this approach for organs of state is completely alien and we will continue to see the vast majority of state contracts overrunning both time and budget.



Chris Binnington