Dispute resolution

The Civil Transactions Law (CTL), issued by Royal Decree M/191 dated 29/11/1444 AH (corresponding to 18 June 2023), which came into force on 16 December 2023, has revolutionized the legal system in the Kingdom of Saudi Arabia (KSA) in relation to civil rights and liabilities.

The CTL can be considered a codification of Shariah principles. As there may be differences of opinion between Shariah schools of thought on particular matters, it was previously uncertain which opinion may be followed by a particular judge, leading to greater uncertainty in judicial outcomes. The purpose of the CTL is to lift this uncertainty, by requiring the judiciary to follow the particular Shariah opinion that has been codified by the legislator, so as to reduce the risk of investment and civil transactions in KSA.

The CTL applies with retrospective effect, except in certain limited circumstances where an existing statutory provision or judicial principle is relied upon by a party, meaning that it will apply to existing contracts and disputes, even if these arose prior to the date on which the CTL came into force.

Overall, the CTL provides that obligations derive from the following five sources: contracts, unilateral acts, harmful acts, unjust enrichment, and the statutory provisions of the CTL.

In this overview, we will consider four commercial contexts in which the CTL is highly relevant, being (i) Pre-contractual negotiations; (ii) contractual risk-allocation; (iii) harmful acts; and (iv) dealing with bad debt.

 

A. Pre-Contractual Negotiations

The CTL provides clarity on the rights of negotiating parties during the pre-contract stage. If you’re involved in negotiating a contract under KSA law, note the following five developments:

1. Heads of Terms

Negotiating parties often agree on the material terms of a commercial agreement by way of Heads of Terms (HOTs), with non-material terms to be fleshed out in a subsequent agreement. The CTL provides that agreement on material terms is enough to form a contractual agreement, even if the parties disagree on non-material terms, unless the parties have expressly agreed that no contract will be formed until the non-material terms are also agreed. The court has the power to determine the non-material terms if the parties are unable to agree these, by reference to applicable law, the type of transaction and custom and practice.

If your commercial intent is for HOTs to be non-binding, make sure this is expressly stated, to avoid a contractual agreement being inadvertently formed at an early stage in the negotiation.

2. Future promises

The CTL offers much-needed clarity in relation to agreements to enter into a contract at a future stage or subject to certain conditions arising (such as an agreement to lease a commercial building once it is constructed, or an agreement to sell shares and exit a company on certain commercial targets being achieved). Previously, such agreements were very much subject to the discretion of the judiciary as to the extent to which they could be deemed enforceable.

The CTL clarifies the default position – a promise to enter into a contractual agreement in the future is not binding unless:

• The parties have agreed all the material terms of the future contract;
• There is a specified time period for the contract to be entered into; and
• Any conditions precedent for the contract have been fulfilled

If these conditions are fulfilled but a party refuses to enter into the contract, the counter-party can seek a court order to require the contract to be entered into.

3. Withdrawing an offer

The CTL confirms the accepted market position, that commercial proposals cannot be withdrawn or amended during the period allowed for the counter-party to consider and accept the offer. If there is no specified time period for acceptance, then the offer can be withdrawn or amended at any time. However, this should be immediately notified to the persons receiving the proposal, as the CTL provides that failure to notify such persons can lead to compensation claims for costs incurred as a result of continuing to rely on the previous offer.

4. Bad faith negotiation

Conducting negotiation with no genuine intent to enter into a contract, or deliberately failing to disclose a material matter that would impact the negotiations, can constitute ‘bad faith’ negotiation.

The CTL provides that a negotiating party who can show that their counter-party negotiated in bad faith can claim compensation for harm caused, which could include costs incurred in the negotiation process. They cannot claim compensation for the anticipated profits that would have been made if the contract had concluded.

5. Misrepresentation and misleading behaviour

A party to a contract can apply to court to have the contract annulled if they can show that they only entered into the contract due to having been deliberately misled by the counter-party in relation to a material term of the contract.

The CTL provides that deliberately remaining silent in order to hide an issue that would have prevented the counter-party from entering into the contract is deemed misleading behaviour for these purposes. If the misleading behaviour arose from another person (not one of the parties to the contract), then the contract parties cannot seek to annul the contract unless it can be shown that the counter-party was aware – or ought to have been aware – of the misleading behaviour.

It remains to be seen how courts will apply such provisions, particularly where contracts have expressly included ‘non-reliance’ clauses to mitigate the risk of contracts being annulled due to allegations of misrepresentation.

B. Contractual Risk-Allocation

The CTL provides welcome confirmation that parties can contractually agree to limitations and exclusions of liability, as well as liquidated damages clauses, allowing greater certainty in the allocation of risk between parties at the commencement of the contractual relationship.

Liquidated damages clauses have long been considered enforceable by KSA courts, unless the amount agreed is so far in excess of the damages that have been suffered by the non-breaching party that to enforce the amount would be unjust.

This position has been reflected in the CTL, but with a more detailed framework to regulate the use of liquidated damages clauses, which cannot be contractually waived by the parties:

1. The liquidated damages amount will not be due if the liable party can show that the party to be compensated has suffered no harm.
2. The liable party can seek a court order to reduce the liquidated damages amount if it is clear that the amount is excessive to the harm suffered.
3. The party to be compensated can seek a court order to increase the liquidated damages amount to equal the actual harm causes, if the harm caused exceeded the liquidated damages amount as a result of the liable party’s deceit or gross error.

Limitations and exclusions of liability have traditionally been subject to the risk of being treated as unenforceable by KSA courts, as there were different Shariah views regarding whether or not such provisions could be upheld. Now, the CTL expressly confirms that provisions limiting or excluding liability arising from failure to perform – or a delay in performing – contractual obligations, are enforceable.

However, the CTL also expressly prohibits the use of contractual clauses that seek to limit or exclude liability arising from:

1. gross error or deceit - a position that is often reflected by contractual drafting in any event; and
2. a harmful act, which is explained in the law to mean any fault that causes harm. This legal restriction reflects a similar position in many jurisdictions in the region, including the UAE, Qatar, Kuwait, Egypt and Jordan, which have each expressly legislated to prohibit such limitations or exclusions of liability applying.

There may be room for argument as to whether an act or omission carried out in the course of performing a contract can be more properly considered a ‘harmful act’ for which liability cannot be waived, or a failure to perform contractual obligations, for which the limitations or exclusions of liability can apply. Therefore, appropriate insurance cover remains an essential arm in a contracting party’s risk-allocation toolkit.

 

C. Liability for Harmful Acts

The CTL recognizes harmful acts as one of the grounds on which liability may arise. Harmful acts relate to faults that cause harm – i.e. a breach of an obligation that results in harm to another. The basis of the obligation in these circumstances would not be contractual, but would arise as a matter of law. The CTL provides that liability for a harmful act can arise from (i) a personal act, (ii) another’s act (vicarious liability) and (iii) custodian liability, which we will consider in turn.

1. Personal Act

The general rule set by the CTL concerning harmful acts is that a person (natural or legal) is liable for compensation if they directly commit any fault that causes harm, unless proven otherwise.

2. Vicarious Liability

In accordance with modern civil law systems and judicial practice in the KSA, the CTL has adopted the principle of vicarious liability; a party will be held liable for the wrongs committed by a third party over whom they are responsible and have control. A typical context for vicarious liability is an employment relationship, which raises the question whether KSA cases will start developing along the lines of other jurisdictions, in which an analysis is made to the extent to which an employer can be liable for employees who commit wrongful acts whilst ‘on a frolic of their own’.

3. Custodian Liability

Under the CTL any person who possesses actual control over an object — whether that control is exercised directly or through others — is considered a custodian of that object. The CTL sets out the circumstances in which the custodian is liable for damage caused by an object under that person’s control unless the custodian can prove otherwise, being harm:

1. caused by animals
2. caused to third parties due to the collapse of all, or part of, a building
3. arising from objects that require special care – whether by their nature or by way of regulatory provision - to prevent their harm.

Exemptions from tort liability

The CTL stipulates that a person who commits a harmful act is not liable if that person can establish that the harm arose:

1. from a cause beyond their control, such as an event of ‘force majeure’, or due to the fault of the aggrieved or third party;
2. as a result of defending themselves, their honour or their property, to the extent necessary to prevent the attack against them;
3. from a legitimate use of their right;
4. from their act as a public official, provided that the conditions stipulated in the CTL are met; or
5. from the act of a non-discerning person (a person who is under the age of seven or who is insane), subject to exceptional cases provided by the CTL.

Apportionment of Liability

The CTL further provides that if the aggrieved person contributed to the causation of, or aggravated, the harm through fault of their own, the aggrieved party shall bear responsibility for the proportion of that harm to which they contributed. Similarly, liability can also be shared and proportioned between multiple tortfeasors. The court will assess how liability should be apportioned according to each tortfeasor’s contribution to the harm, or otherwise it will be apportioned equally if this cannot be determined.

D. Dealing with bad debt

The CTL sets out a detailed regulatory framework relating to debts, on matters such as:

• the right to enforce against a debtor for failing to pay a debt when due;
• creditors’ priority rights, including the unenforceability of certain debtor acts as against creditors;
• consolidation of debts and consolidation among debtors;
• the right to fulfil debts;
• designation of debts to be paid by a debtor when its funds are insufficient to pay all debts; and
• offset of debts.

Two major changes brought in by the CTL are, first, a new framework for guarantee contracts (which are a very common form of credit support in financings for corporates established in the KSA or projects carried out in KSA); and second, the confirmation of the right of creditors to sell debts to others.

Guarantees

Given the retrospective application of the CTL it will apply to all claims under guarantees, regardless of whether the relevant agreement was signed before or after the CTL’s effective date. It will therefore be important for both guarantors and the beneficiaries of guarantees to carefully consider the terms of any guarantees granted in the past to check if their risk profile has changed as a consequence of the new legal framework.

Taking Guarantees

A conservative approach has often been adopted by financiers when putting KSA law guarantees in place, to mitigate the risk of the guarantee being held unenforceable due to breaching the Shariah requirement for certainty. Consequently, rather than uncapped “all monies” guarantees with no expiry date being required from KSA obligors, it is usual for guarantees governed by KSA law to refer to a specific debt as being guaranteed and/or to have a financial cap on the guarantor’s liability. There may also be a specific expiry date for the guarantee, linked to the corresponding date for the underlying financing.

It is likely that this approach will continue even after the CTL comes into force. Whilst the CTL now expressly confirms that guarantees may cover future and conditional debts, it is an express requirement for such guarantees that the amount of the liability is fixed and determined in advance. Further, if a guarantee for a future debt does not have a definite term, the guarantor may withdraw the guarantee if the creditor is notified of the withdrawal before the relevant debt matures, allowing for a reasonable period of time. In light of such provisions it is likely that guarantees will still be drafted with the risk of unenforceability due to uncertainty in mind as the CTL does not remove such risk.

The CTL defines a guarantee as contract under which the guarantor agrees to meet a debtor’s liability against a creditor if the debtor itself fails to satisfy the liability i.e, a secondary obligation.

However, guarantees based on international precedents (such as the LMA standard English law guarantee) will often include both a guarantee and indemnity. Such a structure is adopted so that the indemnity, as a primary obligation of the guarantor, will be effective even where the underlying obligation guaranteed is invalid. When taking guarantees in KSA, there is likely to now be greater consideration by financiers of whether such an indemnity provision should be included in a KSA-law governed agreement, to make the guarantor jointly liable with the primary debtor. This is because the CTL significantly restricts the ability to enforce against a guarantor who is not jointly liable with the debtor to the creditor, as explained in the next section.

Recourse against Guarantors

If a guarantor is not jointly liable with the relevant debtor to the creditor, then certain changes are introduced by the CTL for guarantees that may lead to discharge or termination of the guarantee or even potential liability for the creditor. These new provisions can be summarised as follows:

• a creditor may only take recourse against a guarantor after first taking recourse against the debtor and dispossessing them of their funds;
• in addition, if the creditor has the benefit of security granted by the debtor, direct recourse against the debtor is not permitted before both enforcement of the security[1] and recourse against the debtor and dispossession of their funds;
• a claim may be filed by a guarantor to suspend enforcement proceedings against them until enforcement is carried out against the debtor’s funds first and it then becomes evident that such funds are insufficient (if such a claim is filed, the guarantor is obliged at its expense to direct the creditor to the debtor’s funds, but not to funds that are disputed or located outside KSA);
• the creditor will be liable to the guarantor if the debtor becomes insolvent after the guarantor has directed the creditor to the debtor’s funds without the creditor taking necessary actions in a timely manner;
• if the debt becomes due and the creditor does not bring an action for the debt against the debtor, the guarantor may notify the creditor requiring it to take such action. If the creditor fails to do so within 180 days from the date of such notice, the guarantor is released from guarantee, even if the creditor has granted an extension of time to the debtor (unless with the guarantor’s consent); and
• if the creditor loses relevant security due to their own fault or a liquidation procedure is initiated against the debtor and the creditor does not submit a claim then the guarantor will not be liable under the guarantee to the extent that the debt would have been satisfied from the security or insolvency proceeds.

In light of the above issues, it may be preferable for financiers to structure their guarantees as a joint primary liability for the guarantor if commercially possible, to avoid the restrictions in enforcing against non-jointly liable guarantors.

Joint Guarantors

If there is more than one guarantor of the same debt, then it will be important both from the guarantors’ and the beneficiary’s perspective as part of this risk analysis to consider how the allocation of liability between the guarantors may have changed due to the CTL coming into force. The CTL provides that if there are several guarantors of one debt, it is permitted to bring a claim against any of them for the entire amount, unless they have all provided their guarantees in a single contact which does not mention their joint liability. In that situation it will only be possible to claim against guarantor for their proportionate share of the debt.

Sales of Debts

The CTL allows the buying and selling of debts (which is also known as a transfer or assignment of rights) whereby a creditor assigns their rights in debts to third parties.

This is an important development because such transactions had previously been considered unenforceable under KSA law. The general practice of the KSA courts was to prohibit the sale of a receivable by the creditor to a third party based on a specific interpretation of Shariah dicta, despite the existence of a contrasting view among Shariah scholars that permitted such transactions.  Whilst there are certain alternative Shariah-compliant structures that can be adopted to try and achieve the same effect as a debt sale, they introduce additional complexity into the structure to be enforceable.

One of the key points to note for a sale of a debt after the CTL enters into force is that there is no need for the debtor to consent to the transfer, although there is a requirement that they must be notified of the transfer. Other requirements for a valid transfer are that the seller guarantees that the debt right exists at the time of sale, unless otherwise agreed, or unless the transfer was without consideration. Also, the seller does not have to guarantee that the debtor is solvent, unless otherwise agreed.

The CTL provides that if there is a transfer of rights, such as a debt, all relevant guarantees of the debt will also transfer across, provided that the debtor was duly notified of the sale, or unless the parties agreed otherwise. There is no requirement to notify the guarantor or obtain their consent.

In light of the new statutory provisions, it is recommended that parties to a debt sale should ensure that certain minimum terms are agreed upon in the transfer agreement. Those terms should address at least the following:

• notification to the debtor;
• whether the transferor (or another party) guarantees the repayment of the debt, either at the time of sale or on the due date; and
• whether the transferor guarantees the solvency of the debtor, either at the time of sale or on the due date.

Whilst the changes brought in by the CTL seem to be a game-changer for the secondary debt market, it remains to be seen how these provisions will be implemented in practice, particularly in the context of distressed debt and NPLs. In particular, with the Bankruptcy Law predating the CTL by five years, there is no clear provision in the Bankruptcy Law to detail the impact of an approved creditor transferring its rights in the insolvency to a third party.

As the first such cases start to appear, we anticipate discussion with officeholders and the courts will be needed to achieve the registration of the purchaser as the new approved creditor. Once this is achieved, it may only be a matter of time before NPL trading becomes customary in KSA.

Footnote:

[1] Article 594