Liquidated damages: not negotiable

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Liquidated damages (“LDs”) clauses are par for the course in standard construction contracts. These clauses provide that a contractor is required to pay a pre-determined sum of money, as damages for breaching a particular term of a contract (eg failing to complete the works on time). LDs can benefit both parties to a contract by:

  • providing contractual certainty;
  • not requiring proof of loss;
  • simplifying disputes;
  • inducing performance; and
  • providing a cap on liability.

The topic of LDs is often a red flag to contractors, and so it should be. No contractor wants to be liable for LDs, regardless of the quantum. No amount of planning or program contingency can guarantee that a contractor will not fall behind schedule or miss critical milestones (such as practical completion). Some contractors seek to deal with this issue by simply ignoring it during contract negotiation. The contract is signed and put in the drawer until the project is delayed, and only then do they realise the extent of their exposure.

However, too often, the temptation for parties is to negotiate the sum of LDs at the time of entering into a building contract just as they would any other commercial term. Whilst it seems commercially ideal for the parties to ‘agree’ to the sum of liquidated damages, this is problematic for three reasons.

The first (and perhaps the basis for the second and third reasons) is that, in practice, any agreement reached will depend on the extent of the parties’ bargaining power. Ironically, large contractors with more commercial sway can often negotiate lower LD rates than small builders with no bargaining power (and no way of satisfying such large LD liabilities). This of course has its own inherent risks to the success of a project.

Secondly, at common law, liquidated damages must be a “genuine pre-estimate” of the loss that will be suffered by the non-breaching party in the event that the works are not completed in time. If the amount of LDs cannot be proven to be a genuine pre-estimate of loss as at the time of entering into the contract, it may be held to be a penalty at law and the LDs clause will be unenforceable.  So, if the negotiated LDs rate is too high, there is a real risk that it will be classified by a court as a penalty. But, to prove that a LDs provision is penal would require the aggrieved contractor to commence legal proceedings, which are expensive, stressful and time-consuming. Even then, the contractor may still be liable to the principal to pay such amounts of damages as the principal can satisfactorily evidence. For these reasons, in practice, the fine line between what is a ‘genuine pre- estimate’ and what is a ‘penalty’ is rarely tested.

Thirdly, if the negotiated LDs rate is too low, it may mean that the principal effectively ‘caps’ its ability to recover loss in relation to the particular breach of contract. LDs are usually the sole remedy in relation to a particular breach, so, once the breach occurs (eg failure to bring the works to completion by the date for completion), the principal’s entitlement to recover actual loss is limited to the agreed amount of LDs. A failure by the principal, at the time of entering into a contract, to properly assess the potential heads of loss that it will be exposed to for a later breach of contract can place a wronged principal in a very frustrating and costly position.

Further to the above, there are real dangers in agreeing LDs clauses which only provide for nominal or “nil” damages, or which state that the LDs clause is “not applicable”. As LDs are usually the sole remedy, such clauses may have the completely unintended effect that the contractor is absolved from any liability for damages for late completion or non-performance. In those circumstances, the principal should delete the LDs clause in its entirety and preserve its rights to rely on general damages.

LDs are a useful tool for risk allocation between parties but developers and contractors should ensure that LDs clauses are used properly and avoid the pitfalls set out above.