Loss of Profit & other damages for prolongation of the contract

Abhijeet Kumar[1]


Introduction


1. In works contract, delays and prolongation are inevitable which are entered into for long projects. Prolongations often result in economic hardships. If the terms of the contract provide for recourses or alternatives to address such hardships, then the reliefs are accordingly availed by the affected party. However, if the contract doesn't explicitly provide for recourse in event of such prolongation, then uncertainty and a complex dispute arises for ascertaining the breach, the damage and compensation thereof. Such projects have an arbitration clause for the resolution of disputes. This piece shall attempt to highlight the claims which arise in the event of prolongation of works contract, with a specific focus on construction contracts, and the extent to which an arbitral tribunal can decide upon the damages in the event of prolongation.


Loss of Profit Claims


2. As the term signifies loss of profit is a reduction in profit earning of an entity. In a works contract reduction of profit can occur due to several reasons. For instance, the cost of input of the contractor may increase from what has been anticipated when the contract was entered into, such expenditure is a direct expenditure of the contractor towards the contract. Similarly, the allied expenses of the contractor which are called overhead expenses may also increase during the working of the contract. Each of these will result in lesser profit generated by the contractor if the consideration of the contract has been fixed during the time the contract was entered into. If the terms of the contract do not provide for additional payment to the contractor on account of varied input cost (escalation), the contractor does not have the right to get his losses mitigated even if he incurs a loss in the contract owing to the fluctuation in input cost either on direct input costs or indirect input costs during the term as agreed in the contract.


3. However, if the contract is breached by the owner and thereby the contractor is unable to carry out the work as agreed in the contract this would result in the contractor losing his profit margin in the contract. This would be damage caused to the contractor against which he can claim compensation.


4. In A. T. Brij Paul Singh v. State of Gujarat, (1984) 4 SCC the Hon’ble Supreme Court held that “When a contractor bids for a tender, he expects to earn some profit if his bid is accepted and thereon a works contract is entered into. If the upon execution of such a work contract, the owner/parties entrusting the work commits a breach of contract, the contractor would be entitled to claim damages for loss of profit against the profit he expected to earn in the contract. For evaluation of loss to contractor, minutest details need not be examined a broad evaluation would be sufficient.”


5. Thus, in the event of breach by the owner a contractor is entitled to get his damages mitigated in terms of compensation against the profit which he would have gained had the contract been performed.


Effect of Prolongation of Contract.


6. However, the position of law changes in event of prolongation of the contract i.e. if the contract could not be completed within the time stipulated in the terms of the contract. When the contract is prolonged by the owner, the capacity of the contractor to undertake other projects/ventures is diminished and thereby his profit-earning capacity is affected as well. Further, owing to the prolongation, expenditure on inputs increases and thus profit decreases. Remedies in cases of prolongation in terms of compensation are available against damage suffered.


7. If the prolongation of a Contract is on account of delay by the contractor, generally the contract explicitly provides for damages to be claimed by the owner/employer in such an event. However, if the delay is caused due to faults of the owner case law jurisprudence for damages due to prolongation of work contract comes into the picture.


8. Following are the heads of damages which are generally sought on account of prolongation of contract beyond the agreed period of the contract;


a. Loss of profit

b. Compensation for increased overhead expenses

c. Compensation for escalation of price

d. Compensation for loss due to idle machinery or reduction in productivity.


a. Loss of profit.


9. This loss of profit is not the same as the loss of profit mentioned above in event of a breach of contract. In cases of prolongation of works contract, i.e. breach of the term of the contract to completion within the stipulated time, the prolongation itself doesn't give a rise to claim. To establish the claim for loss of profit due to prolongation of contract, the existence of opportunity is to be established to say that had the contract been timely acted upon the claimant would have earned additional profits given its available resources. In NHAI v. IJM Gayatri Joint Venture 2020(3) Arb LR 463 (Delhi), the Hon’ble Delhi High Court held that “A party should prove, existing opportunity, and that it could not avail the said opportunity due to prolongation which resulted in loss to such the party. The loss would have to be quantified and proved.”


10. For the claim of loss of profit, the certainty of existing opportunity and quantified losses suffered shall be proved. On these lines, the Hon’ble Supreme Court in Bharat Coking Coal Ltd. v. L.K. Ahuja, (2004) 5 SCC 109 has held that "It is not unusual for the contractors to claim loss of profit arising out of diminution, in turn, over on account of delay in the matter of completion of the work. What he should establish in such a situation is that had he received the amount due under the contract, he could have utilized the same for some other business in which he could have earned profit. Unless such a plea is raised and established, a claim for loss of profits could not have been granted. In this case, no such material is available on record. In the absence of any evidence, the arbitrator could not have awarded the same."


11. To assess the quantum of loss of profit, reliance is placed on formulas that are recognized in construction contracts namely: Hudson, Emden Formula, Eichleay Formula. These formulas are also relied upon to assess the quantum of increased expenditure on overhead expenses during the period of prolongation. The same was approved by the Hon’ble Supreme Court in McDermott International Inc. Burn Standard Ltd. and Ors. (2006) 11 SCC 181 (“McDermott case”).


b. Compensation for increased overhead expenses


12. When the arbitral tribunal rejects the claim for increased overhead expenses during the prolongation period on account of no evidence then the Courts tend to uphold such decisions of the Tribunal. The Hon’ble Delhi High Court in Indo Nabin Projects Ltd. v. Powergrid Corporation of India Ltd., 2018 SCC OnLine Del 8405 held that “Standard formulae is an essential tool for computing loss of profit and overhead expenses. However the Arbitral Tribunal is not bound to apply these formulae in every case and absolve the claimant form producing any other material to establish the claims of loss on account of overheads/loss of profit. A claimant should also establish that it incurred overhead expenses on account of prolongation of works contract.”


13. With respect to claim against increased overhead the burden on the claimant of proving enhanced overhead expenses is limited to establishing prolongation of the contract period. If prolongation is proved then the formulas may be applied and thereon compensation can be claimed. Though no statute explicitly provides for applying such formulas but in absence of any impediment, it is acceptable as held by the Hon’ble Supreme Court in McDermott International Inc. Burn Standard Ltd. and Ors (2006) 11 SCC 181. The Supreme Court in this case held that it is left to the discretion of Arbitral Tribunal to determine which formula shall be applied taking into account the facts and circumstances of the case. But the formula for ascertaining increased overhead should be a standard formula one of 3 mentioned in McDermott case. The Hon’ble Delhi High Court in SMS Ltd. v. Konkan Railway Corporation Ltd. MANU/DE/1023/2020, when an unknown formula namely “notional proportionate loss” was applied for ascertaining loss on account of increased overhead and idleness of machinery, set aside the award on account of patent illegality.


14. However, if Arbitral Tribunal denies overhead expenses on account of lack of evidence and states that owing to the lack of evidence of overhead expenses the standard formulas itself cannot be applied. Such refusal of the award has been upheld in the case of Essar Procurement Services Ltd. vs. Paramount Constructions MANU/MH/2511/2016. The Court held that “the award for overhead expenses merely based on the Hudson Formula and not based on any evidence is patently illegal and in conflict with public policy.”


c. Compensation for escalation of prices.


15. In event of prolongation if the prices of direct inputs of the contractor escalates then in such an event if there is any term in the contract concerning such escalation that would prevail. If the contract provides that "the above price is firm and is not subject to any escalation under whatsoever ground till the completion of the work, Then in such a contract, the arbitral tribunal cannot award any compensation despite the escalation beyond the term stipulated as was held by the Supreme Court in New India Civil Erectors (P) Ltd. v. Oil & Natural Gas Corporation, (1997) 11 SCC 75 (“Erectors case”). The Hon’ble Supreme Court recently in NTPC Ltd. v. Deconar Services Pvt. Ltd. AIR 2021 SC 2588 while referring to Erectors case held that construction of the contract is in the domain of Arbitrator and in the view of the said clause arbitrator had rightly denied price escalation in Erectors case.


16. However, the Hon’ble Supreme Court in Food Corporation of India v. A.M. Ahmed & Co. and Anr., (2006) 13 SCC 779 has held that when there is no escalation clause in the contract and the performance of the contract is delayed, then in such a situation, the Arbitral Tribunal upon determination of delay and determination of the escalation of price during the delayed period, can grant compensation for such escalation, if the delay has been caused by the Respondent.


17. It is evident from the abovementioned precedents that if the intent of fixed price for the entire work in a works contract regardless of time taken can be ascertained from the terms of the said contract, then price escalation cannot be granted even if the performance of contract is delayed. On the contrary, if the Contract is silent with respect to price escalation and the performance is delay, then despite the absence of any escalation clause, the aggrieved party can be granted compensation for price escalation on account of delay in performance of the Contract.


18. In another, interesting set of circumstances, the original contract did not provide for price escalation, however, the supplement agreement extending the time for execution provided a prohibition on any claim of price escalation. The Supreme Court of India in K.N. Santhyaapalan (Dead) by Lrs. v. State of Kerala and Ors., 2006 (4) ArbLR275 held that when the owner couldn’t provide necessities for the execution of work as agreed in the contract. The court upheld the award of arbitrator granting claims against price escalation despite there being express prohibition in the supplementary agreement. The reason appears to be that the intention of any legal obligation of the party entering into the first contract and a subsequent one in order to save the first one cannot be the same. In the sense that the parties to a contract would certainly be free in terms of the influence of losing something on their decision-making w.r.t. entering into a new contract but once the contract has prolonged the parties might already be losing and thus to save it, they entered into a supplementary agreement. This ingredient of compulsion appears to have played a role in the decision of the Court to uphold the award.


19. Thus, the takeaway from the aforesaid discussion is that, in absence of any bar on price escalation in the contract, the Arbitral Tribunal will have jurisdiction to grant compensation to the Claimant against damages suffered due to prolongation of the contract. However, an explicit bar on such a claim until the completion of the contract would prohibit this claim. In such instances of delay, the intent of keeping the prices fixed can be ascertained as understood by the dictum of the apex court in Erectors case.

20. Such strict interpretation of a clause barring price escalation in event of delay can often go significantly detrimental to the interest of the aggrieved party. For instance, if the performance of the works contract is delayed on account of the fault of the owner even for a decade then also the clause fixing the price until completion of the contract would be effective against price escalation. The contractor might not have anticipated such inordinate delay while agreeing to such a term but will have to face the consequences thereof. Thus the dictum of the apex court in Erectors case might need a reconsideration if peculiar facts of a case crop up wherein the bar on price escalation is used to exploit the interest of the contractor for a prolonged period of time.


d. Compensation for loss due to idle machinery or reduction in productivity.


21. In M/s National Highways Authority of India v. M/s Hindustan Construction Company, MANU/DE/0438/2016, the Hon’ble Delhi High Court has held that Reliance on the Ministry of Road Transport & Highway's Standard Data Book is an accepted mechanism for assessing the loss due to idle machinery. Against the underutilization of machinery during the prolongation of the contract, the contractor can claim damages to the tune of underutilization. For allowing this claim the Arbitrator only need to ensure that there was idleness of the machinery and the owner is responsible for prolongation. Even if actual damages in terms of money cannot be ascertained in such situation the Standard Data Book of the Ministry of Road Transport & Highways can be relied upon which provides for rates of several types of machinery deployed in construction activities. However, the Delhi High Court in Union of India v. Om Construction Co., 2019 SCC OnLine Del 9037 has held that if the contractor also equally prolonged and the prolongation is attributable to both the parties equally then the damages under this head cannot be awarded. Thus it can be said that once the contractor has mobilized its machinery and brought it on to the site, then his losses due to idleness of such machinery on account of prolongation by owner’s fault will be compensated.


Overlapping of Claims of loss of profit and extra expenses incurred


22. There can be a loss of profitability on account of various factors in event of prolongation of the contract. However, the recourse to seek damages against all such losses if brought under the purview of loss of profit will result in overlapping of claims. Moreover, for the loss of profit claim to be awarded, the burden of proof is relatively higher as opposed to the other claims such as increased overhead, price escalation, losses due to idle machinery. The proof of alternative venture in claims of loss of profit is mandatory.


23. In M/s National Highways Authority of India v. M/s Hindustan Construction Company, MANU/DE/0438/2016, the Hon’ble Delhi High Court has distinguished the claim for loss of profit and loss of earning capacity as “The court distinguished loss of profit and earning capacity, loss of earning capacity means the loss suffered by contractor due to his inability to deploy his manpower, plant, machinery at another venture deployed at the site during the extended period.”


24. Thus, it can be said that the claims of loss of profit as discussed above is essentially loss of earning capacity and the rest are losses suffered to profitability on account of enhanced expenses due to prolongation.


25. Similarly, in NHAI v. IJM Gayatri Joint Venture 2020(3) Arb LR 463 (Delhi) the Delhi High Court held that when the compensation for delay in payment and extra work was paid, additional claim of loss of profit is to be denied.


26. Therefore, if the claims in any manner are encroaching upon ingredients of each other to the extent of such overlapping the awards of the arbitral tribunal will be set aside under Section 34 of A&C, Act.


Conclusion


27. While claiming account of losses suffered due to prolongation of contract certain things shall be kept in mind. The requirement of evidence for claims under the head of loss of profit is relatively higher given it requires an existing opportunity. As far as the requirement of evidence against claims of overhead expenses, idle/underutilized machinery is concerned prolongation on account of fault of other party i.e. the owner shall be proved by the contractor. Accordingly, if the counsel for such aggrieved contractor shall in an arbitration decides to proceed with claim under head of overhead expenses, idle/underutilized machinery burden of proof would be relatively lesser as against under the head of loss of profit. At the same time the Arbitrators are required to be cautious that claims of loss of profit are not sought under the guise of overhead expenses or idle machinery in order to escape the requirement of evidence.


28. Overlapping of claims before a tribunal can subsequently be set aside. Thus, even though increased expenses on idle machinery, price escalation, increased overhead expenses might result in decreased profit. It shall not be claimed under the head of "loss of profit". Moreover, overlapping of claims shall be avoided.


29. Further in the light of Ssangyong Engineering and Construction Co. Ltd v. NHAI (2019) 15 SCC 131 (“Ssangyong case”), which states that an award arrived at without any evidence would be liable to set aside, it would be interesting to see whether the evidence of delay for claims of increased overhead expenses, losses due to idle machinery owing to the prolongation of works contract is sufficient or actual damages will have to be established. Presently it appears that if the Arbitral Tribunal awards claim under heads of increased overhead expenses, idle machinery either only on the evidence of prolongation or deny on account of non-availability of the alternative venture, both kinds of awards are not interfered by the court and Arbitral Tribunal's discretion is allowed to prevail. This position of law appears to have created an anomaly because virtually both of the views of Arbitral Tribunal stands approved by the courts. The necessity of evidence as envisaged in Ssangyong case may be incorporated in claims of damages on account of overhead expenses & idle machinery, this would give a certainty to the jurisprudence of these claims. The extent to which evidence is essential if defined by the court would also be fruitful in bringing certainty with respect to claims on account of overhead expenses and idle machinery.


[1] 4th Year, 7th Semester B.B.A., LL.B.(Hons.) student at Chanakya National Law University. Email – abhijeetcnlu23@gmail.com

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