Civil Law and UAE: Perverse Incentives Created by Legal Rules

1. Introduction

The expression “perverse incentives created by legal rules” describes a situation where a legal rule, although designed to achieve a legitimate objective, may encourage parties to behave in a way that produces the opposite of the rule's intended result.

In UAE civil law, this issue can arise in areas such as:

• contractual performance;
• termination;
• penalty and agreed-compensation clauses;
• security and enforcement;
• litigation;
• abuse of rights;
• limitation periods;
• force majeure and hardship;
• damages;
• procedural remedies.

For example, if a contractual remedy is automatically available whenever a particular event occurs, a party might have an incentive to engineer that event. Similarly, if a party can obtain a substantial contractual payment merely by characterising an amount as a “penalty,” the legal system needs safeguards against opportunistic use of the clause.

The UAE legal system addresses these risks through good faith, abuse-of-rights doctrine, proportionality, judicial supervision, causation, proof of damage, and mandatory statutory rules.

A significant current-law point is that Federal Decree-Law No. 25 of 2025 on the Civil Transactions Law came into force on 1 June 2026, replacing the 1985 Civil Transactions Law. The new framework retains important principles concerning good faith and abuse of rights. Article 221 establishes good-faith contractual performance, while Article 106 addresses unlawful exercise of rights.

2. Meaning of a Perverse Incentive

A perverse incentive occurs where:

The legal consequence attached to conduct makes a party economically or strategically better off by engaging in behaviour that the legal rule was not intended to encourage.

Simple example

Suppose a contract gives Party A a large payment if Party B fails to complete a project.

If Party A deliberately prevents B from completing the project and then claims the contractual payment, the rule may create an incentive for A to cause the very breach for which compensation is claimed.

That is a perverse incentive.

3. Why Perverse Incentives Matter in Civil Law

Civil-law rules generally attempt to encourage:

• contractual reliability;
• cooperation;
• compensation for genuine loss;
• efficient dispute resolution;
• lawful exercise of rights;
• protection of legitimate expectations.

A poorly designed or improperly applied rule can instead encourage:

• strategic breach;
• opportunistic termination;
• excessive litigation;
• deliberate delay;
• manipulation of evidence;
• artificial claims;
• avoidance of contractual obligations;
• exploitation of procedural rights.

Therefore, courts often need to interpret rules in a way that preserves their legitimate purpose without allowing them to become instruments of abuse.

4. UAE Legal Mechanisms Controlling Perverse Incentives

The principal safeguards include:

1. Good faith

Contracts must be performed consistently with good faith.

2. Abuse of rights

A formally existing legal right may become unlawful if exercised in one of the circumstances identified by Article 106.

3. Proportionality

Disproportion between the benefit obtained and harm inflicted may be relevant to determining whether a right has been abused.

4. Judicial control

Courts may supervise contractual remedies and compensation.

5. Causation

A claimant normally must establish a legally relevant connection between the wrongful conduct and the claimed loss.

6. Mandatory rules

Parties cannot contract out of certain mandatory statutory protections.

7. Good-faith cooperation

A party should not deliberately frustrate the performance of the other party and then profit from the resulting failure.

5. Article 106 — Abuse of Rights

Article 106 is particularly important to the problem of perverse incentives.

The provision treats exercise of a right as unlawful in circumstances including:

• intent to cause harm;
• pursuit of an interest contrary to law, public order or morals;
• a disproportionate benefit compared with the harm caused;
• exceeding accepted customary limits.

The principle is therefore:

Having a legal right does not mean that every possible use of that right is legally protected.

This is an important anti-opportunism mechanism.

6. Good Faith as an Anti-Perverse-Incentive Principle

Article 221 of the new Civil Transactions Law provides that a contract must be performed:

according to its contents and consistently with the requirements of good faith.

The provision also recognises that contractual obligations can extend beyond express words to matters arising from:

• law;
• custom;
• the nature of the obligation.

Thus, good faith can prevent a party from exploiting a technical contractual entitlement in a way that defeats the legitimate purpose of the contractual relationship.

7. Perverse Incentives in Contractual Termination

Termination rights can create incentives for opportunistic behaviour.

Example

A contract contains a termination clause allowing termination following a specified event.

One party may attempt to:

1. create the event;
2. invoke the termination clause;
3. avoid its own obligations;
4. claim damages against the counterparty.

This produces a potential self-induced breach problem.

The court may therefore examine:

• who caused the triggering event;
• contractual purpose;
• good faith;
• causation;
• actual loss;
• whether the termination right was exercised according to the contract.

The mere existence of a contractual power does not necessarily immunise abusive exercise of that power.

8. Perverse Incentives and Penalty Clauses

Agreed compensation can also create incentives for opportunism.

Historically, under former Article 390, UAE courts treated an agreed compensation clause as a contractual assessment of damage but retained power to adjust it where the statutory requirements were satisfied.

In Union Supreme Court Appeal No. 370 of Judicial Year 20, judgment of 2 May 2000, the Court explained that a penalty clause generally relieved the creditor of initially proving the amount of damage, while the debtor could seek reduction by demonstrating that the agreed amount was excessive or that the presumed damage did not correspond to the actual position.

The current equivalent is Article 340 of the new Civil Transactions Law.

Anti-perverse-incentive function

Judicial adjustment prevents a party from deliberately structuring a contractual penalty as an economically excessive reward.

9. Case Law 1 — Union Supreme Court, Appeal No. 370/20, 2 May 2000

Issue

Agreed compensation / penalty clause.

Principle

The Court treated the agreed amount as a contractual assessment of damage. The creditor did not ordinarily have to establish the amount of damage from the beginning.

However, the debtor could challenge the amount and seek judicial adjustment where the statutory conditions were satisfied.

Relevance

This prevents the contractual penalty from becoming an automatic windfall.

It creates a balance:

Contractual certainty + Judicial control

The case was decided under former Article 390 and therefore should be regarded as historical authority when analysing the current Article 340.

10. Case Law 2 — Dubai Court of Cassation, Judgment No. 138/94

Issue

Contractual delay damages in a construction context.

Principle

The Dubai Court of Cassation recognised the ability of the court to reduce agreed damages where the contractual amount did not correspond appropriately to the actual damage.

Perverse-incentive relevance

Without judicial adjustment, an excessive delay clause could encourage a claimant to prefer contractual default payments over commercially reasonable cooperation or mitigation.

The judicial power to adjust damages therefore discourages opportunistic exploitation of the clause.

This authority arose under former Article 390 and is consequently historical in relation to current Article 340.

11. Case Law 3 — Dubai Court of Cassation, Appeal No. 222/2005, Judgment of 19 June 2006

Principle

The Court addressed agreed compensation and the relationship between the contractual amount and actual damage.

The case illustrates that agreed compensation does not completely remove judicial scrutiny.

Importance

A contractual clause should not automatically become a mechanism for obtaining compensation unrelated to the real consequences of breach.

Thus:

Contractual amount ≠ automatic immunity from judicial review

This is particularly important in construction and commercial contracts.

12. Case Law 4 — Dubai Court of Cassation, Petitions Nos. 63 and 99 of 2005, Judgment of 26 July 2005

Issue

Agreed damages and proof.

Principle

The existence of an agreed compensation clause affects the evidentiary position, but it does not eliminate the court's responsibility to determine the legally relevant circumstances.

Where actual loss requires technical assessment, expert evidence may be relevant.

Perverse-incentive relevance

This reduces the risk that a claimant can simply insert a large number into a contract and later obtain it without meaningful examination of the underlying circumstances.

13. Case Law 5 — Abu Dhabi Court of Cassation, Appeal No. 941/2009

Principle

The agreed-damages provision creates a contractual assessment of damage, but the debtor may challenge the amount and demonstrate that it is excessive or that the underlying damage did not occur as presumed.

Relevance

The decision illustrates the balancing mechanism between:

• freedom of contract; and
• prevention of unjust enrichment through excessive agreed compensation.

Again, this authority concerns former Article 390 and should be read alongside current Article 340.

14. Case Law 6 — Dubai Court of Cassation, Case No. 302/21, Judgment of 17 June 2001

Issue

Delay penalties following termination.

Principle

The Court treated ordinary delay penalties as ancillary to the primary contractual obligation.

Where the principal obligation ceased to operate following termination, the ordinary ancillary delay penalty could also cease to have effect, subject to the particular contractual structure.

Perverse-incentive significance

This prevents a party from treating an ancillary penalty as an independent source of continuing income after the underlying contractual obligation has ceased.

The case therefore illustrates the principle:

A remedy should normally remain connected to the obligation it was designed to protect.

15. Case Law 7 — Abu Dhabi Court of Cassation, Commercial Appeal No. 790/2013, Judgment of 22 October 2014

Issue

Effect of termination on agreed compensation.

Principle

The Court distinguished between:

1. an ordinary ancillary penalty associated with non-performance during the contract; and
2. a clause independently designed to compensate for termination and expressly intended to survive termination.

The second category may continue after termination depending on its wording and purpose.

Perverse-incentive relevance

This prevents parties from assuming that every contractual penalty automatically disappears—or automatically survives—termination.

The court examines the substance and purpose of the clause.

16. Case Law 8 — Dubai Court of Cassation, Civil Appeal No. 440/2025

Issue

Abuse of the right to resort to legal procedures.

The Court considered the circumstances in which the exercise of a legal right can become abusive.

The reported principle is that resorting to legal procedures is ordinarily a legitimate exercise of a right, but liability can arise where the legal criteria for abuse are established. The burden of establishing abuse remains important.

Perverse-incentive relevance

If every unsuccessful complaint automatically generated civil liability, people could be discouraged from legitimately reporting suspected wrongdoing.

Conversely, if legal procedures could be used deliberately to harass others without consequences, the system could encourage abusive litigation.

The abuse-of-rights doctrine attempts to maintain the balance.

17. Case Law 9 — Dubai Court of Cassation, Judgment No. 288/2025

Issue

Good-faith contractual performance.

The decision has been discussed as emphasising:

• honest performance;
• avoidance of deception;
• cooperation;
• protection of legitimate interests;
• avoidance of abusive conduct.

Perverse-incentive significance

The decision illustrates why contractual rights cannot always be evaluated solely through literal wording.

A party should not be able to exploit a technical contractual mechanism to deliberately frustrate the contractual relationship and then claim that the resulting consequences are entirely attributable to the other party.

18. Case Law 10 — Sky News Arabia FZ-LLC v Kassab Media FZ (LLC) [2018] DIFC CFI 067

This is a DIFC Court case and should not be confused with a mainland UAE Court of Cassation decision.

The defendant argued that minimum guaranteed payments constituted a penalty under former Article 390.

The DIFC Court concluded that the minimum-guarantee payments were not compensation for breach. They represented consideration for the limited exclusivity granted under the agreement.

Importance

The case shows that courts look at the commercial substance and function of a clause, rather than merely its label.

Perverse-incentive significance

If every commercially negotiated payment were automatically characterised as a penalty, parties might have incentives to avoid economically useful contractual structures.

Conversely, genuinely punitive clauses can be controlled under the relevant law.

19. Perverse Incentives and Litigation

Legal rules can sometimes create incentives for excessive litigation.

For example, a party might bring proceedings not primarily to obtain a legitimate remedy but to:

• delay payment;
• increase the opponent's costs;
• obstruct a commercial transaction;
• create negotiating pressure;
• obtain tactical leverage.

The abuse-of-rights doctrine provides an important limitation.

The principle is not:

"Litigation is bad."

Rather:

Legitimate access to justice is protected, while abusive exercise of procedural rights can attract legal consequences.

Recent Dubai decisions illustrate this distinction: unsuccessful criminal or legal complaints do not automatically constitute abuse; evidence of improper purpose, bad faith or other recognised grounds is required.

20. Perverse Incentives and Limitation Periods

Limitation rules serve an important purpose:

• certainty;
• finality;
• preservation of evidence;
• protection against stale claims.

But limitation rules can also create strategic incentives.

A claimant may delay proceedings hoping that evidence will become unavailable, while a defendant may rely on the passage of time to defeat a claim.

Therefore, limitation law must balance:

Finality ↔ Access to justice

UAE jurisprudence has distinguished different limitation regimes depending on the legal basis of the claim. A reported English decision considering UAE law noted the distinction between limitation applicable to tort claims and the longer period historically associated with abuse-of-right claims.

21. Perverse Incentives and Force Majeure

Force majeure provisions protect parties from liability where extraordinary external events prevent performance.

But a poorly applied force-majeure rule could encourage a party to:

• stop performing too quickly;
• classify ordinary commercial difficulty as force majeure;
• avoid mitigation;
• invoke external events that did not actually prevent performance.

Therefore, courts must distinguish:

Genuine prevention

from

Mere inconvenience or increased expense.

The recent Abu Dhabi Court of Cassation Appeal No. 207/2026 illustrates the importance of evidence concerning the external event, governmental intervention, expert findings and causal connection between the event and inability to perform.

22. Perverse Incentives and Hardship

Hardship rules create another potential incentive problem.

If a court automatically relieves a party whenever performance becomes expensive, parties might have an incentive to:

• underprice contracts;
• accept excessive risk;
• enter speculative contracts;
• later request judicial adjustment.

The law therefore has to distinguish genuine exceptional circumstances from ordinary commercial risk.

The new Civil Transactions Law contains a framework for exceptional circumstances, allowing judicial intervention in qualifying situations where unforeseen circumstances make performance exceptionally onerous and threaten severe loss.

23. Perverse Incentives in Security Enforcement

Security interests, guarantees and enforcement mechanisms are designed to protect creditors.

However, excessive or strategically timed enforcement could:

• destroy a viable business;
• create disproportionate pressure;
• encourage premature default;
• produce unnecessary asset sales.

Therefore, contractual and statutory enforcement rights remain subject to the wider UAE principles of:

• good faith;
• abuse of rights;
• proportionality;
• applicable procedural safeguards.

24. Perverse Incentives in Construction Contracts

Construction contracts are particularly susceptible to incentive problems.

Example

Suppose a contractor receives a bonus for early completion.

The contractor may have an incentive to:

• accelerate excessively;
• reduce quality;
• omit necessary testing.

Conversely, a large delay penalty may create an incentive to:

• blame the employer;
• exaggerate extension-of-time claims;
• manipulate delay records.

Therefore, construction law often requires examination of:

• actual delay;
• causation;
• concurrent delay;
• employer-caused delay;
• contractor-caused delay;
• mitigation;
• actual damage;
• contractual allocation of risk.

25. Perverse Incentives and Digital Contracts

Modern digital contracts can create new incentive problems.

For example, a platform may possess a contractual right to:

• suspend an account;
• withhold payments;
• terminate a service;
• impose automated restrictions.

If these powers are exercised purely algorithmically, a party might receive an economic benefit from automatically classifying another party as being in default.

The relevant legal questions include:

• Was the contractual trigger actually satisfied?
• Was the system accurate?
• Was the decision made in good faith?
• Was the contractual right used for its legitimate purpose?
• Was there disproportionate harm?
• Did the affected party have a contractual or statutory remedy?

The existence of automation does not eliminate ordinary civil-law principles.

26. Perverse Incentives and Damages

Damages should generally compensate legally recognised loss rather than create an unjustified windfall.

A damages system therefore has to balance:

Under-compensation

against

Over-compensation

If damages are too low:

breach may become economically attractive.

If damages are excessive:

litigation or opportunistic claims may become economically attractive.

The optimal legal objective is therefore not simply "maximum damages."

It is to establish a legally justified remedy connected to:

• breach;
• causation;
• damage;
• foreseeability or applicable legal limits;
• contractual allocation of risk.

27. Perverse Incentives and Good-Faith Cooperation

Consider:

A must provide information to B.

B cannot complete its obligation without that information.

A deliberately withholds it and later argues:

"B failed to perform."

Such conduct could create an obvious perverse incentive.

The legal system therefore needs the principle that a party should not profit from circumstances that it deliberately created.

This is one of the practical functions of good faith and abuse-of-right doctrines.

28. Economic Analysis of UAE Civil-Law Rules

The concept can be represented as follows:

Intended rule

Legal rule → Desired behaviour → Social/economic objective

But sometimes:

Perverse incentive

Legal rule → Private strategic benefit → Undesired behaviour → Social cost

The judicial response may therefore be:

Legal rule + Good faith + Proportionality + Causation + Abuse-of-rights control

29. Important Distinction: Perverse Incentive Does Not Mean Bad Law

The existence of a potential perverse incentive does not automatically mean that the legal rule is defective.

For example, a penalty clause has a legitimate function:

• encouraging timely performance;
• allocating risk;
• reducing litigation over damages;
• increasing contractual certainty.

The problem arises when the clause is used in a manner that defeats those legitimate purposes.

Therefore, the analysis should distinguish:

Legitimate incentive

from

Excessive incentive

from

Perverse incentive.

30. Six Major UAE Case-Law Lessons

31. Practical Examples

Example 1 — Termination

A company has a contractual termination right.

It deliberately creates the circumstances permitting termination solely to avoid paying the counterparty.

Issue: Possible abuse of contractual rights.

Example 2 — Penalty Clause

A contract imposes AED 5 million for a minor delay causing AED 20,000 of actual loss.

Issue: Judicial scrutiny of agreed compensation.

Example 3 — Litigation

A party repeatedly files proceedings solely to delay the other party's business operations.

Issue: Potential abuse of procedural rights.

Example 4 — Force Majeure

A party claims force majeure merely because performance became more expensive.

Issue: Increased cost is not automatically equivalent to legally established prevention.

Example 5 — Construction

An employer prevents site access and later imposes delay penalties on the contractor.

Issue: The party responsible for preventing performance may face difficulties in relying on the resulting delay.

32. Exam-Oriented Analysis

If asked:

“Discuss perverse incentives created by legal rules under UAE civil law.”

Use the following structure:

Step 1 — Identify the legal rule

What right, remedy or obligation does the rule create?

Step 2 — Identify the intended purpose

Why did the legislature create the rule?

Step 3 — Identify the strategic response

How could a party exploit the rule?

Step 4 — Identify the resulting incentive

Would exploitation encourage:

• breach?
• delay?
• litigation?
• excessive damages?
• termination?
• withholding?
• procedural abuse?

Step 5 — Apply UAE safeguards

Consider:

• good faith;
• Article 106;
• proportionality;
• causation;
• statutory limitations;
• judicial supervision.

Step 6 — Apply case law

Use the relevant UAE Court of Cassation authority.

33. Quick Revision Formula

LEGAL RULE
↓
RIGHT / REMEDY
↓
PRIVATE INCENTIVE
↓
STRATEGIC BEHAVIOUR
↓
POSSIBLE SOCIAL HARM
↓
GOOD FAITH + ABUSE OF RIGHTS + PROPORTIONALITY
↓
JUDICIAL CONTROL

34. Conclusion

Perverse incentives created by legal rules is an important analytical concept in UAE civil law because legal rights and remedies can sometimes be strategically exploited.

The UAE system addresses this problem through several interconnected principles:

1. Binding force of contracts
2. Good-faith performance
3. Abuse-of-rights doctrine
4. Proportionality
5. Causation
6. Judicial supervision of agreed compensation
7. Protection against abusive litigation
8. Control of excessive contractual remedies
9. Recognition of legitimate excuses such as force majeure
10. Protection of legitimate contractual expectations

The central principle can be remembered as:

A legal rule should protect legitimate rights without allowing those rights to become instruments for opportunistic harm.

For current UAE law, Article 221's good-faith requirement and Article 106's abuse-of-rights doctrine are particularly important. The older cases under the 1985 Civil Transactions Law remain valuable for understanding how UAE courts developed these principles, but they should be distinguished from direct interpretations of the new Civil Transactions Law that has applied since 1 June 2026.