In the construction industry liquidated damages is a well-known, well used contractual mechanism allowing parties to allocate risk, incentivise timely completion, and more easily obtain compensation for contractual breaches (as opposed to other types of damages). However, incorrect drafting or attempted application of liquidated damages can have unintended (and sometimes severe) impacts on the parties’ entitlement to compensation.
To ensure your liquidated damages clause is operative and effective, careful consideration of the wording and its proposed operation is required. Failure to understand the purpose of liquidated damages can result in an invalid clause, and an uncompensated party.
This three-part series will discuss:
- What are liquidated damages, the differences between them and general damages, and the advantages of a contractual liquidated damages mechanism (Part 1);
- circumstances where liquidated damages may constitute a penalty or may otherwise be considered invalid or void, as well as drafting considerations to ensure its operation remains valid and effective (Part 2); and
- circumstances where the right to liquidated damages may be lost, including a consideration of the “prevention principal”, and further drafting considerations to ensure the protection of a party’s rights to compensation (Part 3).
What are Liquidated Damages?
As a concept, “liquidated damages” refers to monies which is agreed to be paid, at a specified rate, on breach of the contract.
In the construction industry, liquidated damages are often applied as a daily or weekly rate, which is agreed between the parties during the contract negotiation phase, and is then included in the terms of contract. This commonly used tool for compensation allows the parties to allocate risk, obtain a degree of certainty regarding the consequences for a breach, and avoids the time and cost associated with substantiating and making a claim for general damages.
Under construction contracts, liquidated damages are most commonly payable by the contractor to the principal/owner for every day or week past the date for completion of a project, due to non-delivery of a project by the specified date.
Liquidated Damaged v General Damages
Liquidated damages are not general damages – rather than being a fixed in advance of a breach and recoverable without proof of loss, general damages can only be awarded by a court once proof of loss has been assessed following a determination of a party’s breach of contract. Based on this inconvenience alone, liquidated damages provides a cleaner, easier, more certain, and more effective way to secure performance of a contract and claim compensation for damage suffered as a result of a breach.
Whilst it sounds enticing, the parties must be careful in inserting a contractual entitlement for liquidated damages if they intend on claiming general damages – a party cannot claim both, and generally, where an entitlement for liquidated damages exists, the parties will be bound by that entitlement and will be unable to claim general damages in addition to, or instead of liquidated damages.
Whether a liquidated damages clause is intended to apply as an exclusive remedy to the principal to compensate for the contractor’s breach, will be a matter of construction. However, the following two factors assist in determining that exclusive application – where they are present in the clause, it is more likely that the parties intended this remedy to exclusively apply:
- Where there is a positive sum or specified rate of liquidated damages stated in the contract (i.e., the contract does not merely state $0 or nil); and
- The wording of the clause is mandatory (i.e., the contractor shall pay liquidated damages), even in circumstances where the specified rate is “nil”. In this instance, the insertion of “nil” can indicate that the clause was intended to be the sole remedy, but the parties have agreed there should be no entitlement to damages for delayed completion.
Where a clause is found to be the sole remedy for delayed completion (as the relevant breach, for example), and is otherwise a valid and enforceable clause, the parties will be bound by these terms, and this will be the only available route for compensation for that breach, even if the actual loss incurred by the principal (as a result of the breach) exceeds its entitlement to liquidated damages (e.g. where the specified rate is “$1 per day”).
Notwithstanding the above, general damages may be claimable in circumstances where a liquidated damages clause fails to operate due being void, being found to constitute a penalty (which will be discussed in Part 2), or where the prevention principle applies (which will be discussed in Part 3).
Advantages of Liquidated Damages Clauses
A liquidated damages clause is distinct from other types of clauses regarding compensation generally found in construction contracts, and should not simply be overlooked. These other clauses include:
- Indemnity clauses (where the party in breach indemnifies the other party for loss it suffers as a result of that breach), as unlike a liquidated damages clause, the compensation payable under an indemnity is not known until the breach has occurred and the loss has been incurred and proven; and
- Clauses where the sum payable in respect of the breach is fixed by a third party (for example, a judge) after the breach, rather than being an amount fixed into the contract.
A properly drafted liquidated damages clause is an essential element of any construction contract, and its inclusion in a construction contract can be advantageous to both parties, as it:
- Provides certainty to both parties regarding the amount it will be compensated / liable to pay as a result of the specified breach;
- Assists in the risk allocation of the contract as both parties can accurately determine the rights and liabilities resulting from the specified breach;
- Encourages the contractor to work efficiently and deliver the project on-time / incentivises timely performance under the contract;
- Allows the contractor (during the tender / contract negotiation phase) to negotiate the rate of liquidated damages, and price its bid accordingly;
- Establishes a cap on the liability associated with the specified breach (as most contracts will contain a cap on the amount of liquidated damages payable); and
- Facilitates the recovery of damages without the difficulty and expense or proving loss.
Part 2 of this Series will discuss the important drafting considerations and key information to include to ensure that your liquidated damages clause is valid and effective.
Lamont Project & Construction Lawyers
Our Team have the industry knowledge and experience to assist both principals and contractors in all major projects and contractual disputes. If you would like to discuss any matters raised in the above article or the forthcoming series as it relates to your specific circumstances, please contact Lamont Project & Construction Lawyers.
The contents of this article is for information purposes only; it does not discuss every important topic or matter of law, and it is not to be relied upon as legal advice. Specialist advice should be sought regarding your specific circumstances.
Contact: Peter Lamont or Lili Hoelscher
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