Liquidated Damages: Part 2 – Too Good To Be True?

Liquidated damages clauses are commonly upheld to be enforceable, even if the result of that clause may seem “unfair”, for example, where the clause only entitles the injured party to a nominal amount.

In assessing an entitlement, Courts will turn their attention towards whether the effect of the clause is such that it would be considered a “penalty”, and in doing so, will consider whether the quantum of the liquidated damages is a “genuine pre-estimate” of the loss that party is likely to suffer as a result of the other party’s breach.

Like all things, the devil is in the detail – careful consideration must be given to the wording, and amount, contained in a liquidated damages clause to ensure that it remains a valid and enforceable means for compensation. With considered drafting, a liquidated damages clause can both, stimulate performance, and compensate late completion.

Penalty

A “penalty” will arise where the clause aims to (or unintentionally) punishes a party for non-observance of a contractual obligation.

If a clause is found to constitute a penalty, it will have no legal effect and will be unenforceable. Whilst it will be dependent on the circumstances of each contract, the Courts have provided some guidance through various tests and considerations which assist in determining whether or not a liquidated damages clause, constitutes a penalty.

These factors include:

1. Where the sum (or rate) of liquidated damages is an extravagant and unconscionable amount when compared to the greatest loss that flows from the breach;
2. If the relevant contractor breach (which would raise an entitlement to liquidated damages) relates solely to the non-payment of money, and the principal’s entitlement would exceed the amount which should have been paid by the contractor; and
3. The amount of liquidated damages is a single lump sum, which is payable on the occurrence of one or a range of breaches, which vary in seriousness and some only warrant trivial damages.

A key factor in determining whether the entitlement is extravagant and unconscionable, is whether the amount being claimed by the party entitled to compensation, is “out of proportion” with all the loss they are likely to suffer. In other words, the clause will not be unenforceable simply because there is some difference in value between amount a party is entitled to be compensated, and the loss actually suffered – it must instead be totally disproportionate.

Examples where the Courts have found that a liquidated damages clause may constitute a penalty include:

1. Where the sum does not compensate the principal for the delay to practical completion because that delay is incapable of causing any financial loss (and is therefore extravagant in comparison with the greatest loss that could have been be suffered by reason of delay);
2. Where the rate of liquidated damages for delayed completion of a project was exceptionally high when compared to other similar contracts and entitlements for the same breach;
3. Where the amount payable does not protect the principal’s legitimate commercial interests;
4. Where the clause punishes the contractor, rather than compensating the principal; and
5. Where an entitlement to liquidated damages arises under a contract, and is payable, upon an event that did not amount to a breach of contract.

Plainly, a liquidated damages clause will be found to constitute a penalty where, in all the circumstances, the rate of compensation is not considered to be a “genuine pre-estimate” of the principal’s loss.

Drafting Considerations – Genuine Pre-Estimate

Whilst it is the effect of the clause (rather than the words used) which will determine whether a liquidated damage clause constitutes a penalty, careful consideration should be given to the circumstances in which an entitlement to claim liquidated damages will arise, as well as the compensation rate, to ensure the clause remains effective and enforceable.

As mentioned above, a liquidated damages clause will constitute a penalty if the rate for compensation is not a genuine pre-estimate of the principal’s loss.

When drafting your liquidated damages clause, ensure the rate stipulated reflects the negotiated level of risk that the parties agree to in circumstances of a breach, and that it is otherwise a “genuine pre-estimate” of the principal’s loss, calculated at the time of entering into the contract.

Key items to consider when preparing your clause, include:

1. An amount is not a genuine pre-estimate, merely because one party believes it to be – it must objectively be so;
2. For commercial projects, this amount can often be estimated by calculating possible heads of loss, which may include loss of rent / delayed profit of sale, additional supervision, and admin costs – it can be helpful where the parties identify the sum / formula, or assumptions applied in calculating the rate of liquidated damages;
3. Do not simply insert $1 or “nil”, and ensure to always check for any default values which may exist in your standard or template contract; and
4. Note in your clause that the parties agree the rate of liquidated damages constitutes a “genuine pre-estimate” (although this alone is not sufficient to prevent your clause from being invalidated as a penalty).

Entitlement to General Damages

As mentioned in Part 1 of this Series, generally, where a valid and enforceable clause exists, parties cannot claim general damages in addition to, or instead of, liquidated damages. However, where the court finds that the clause constitutes a penalty (and is therefore no longer valid and enforceable), the injured party will be entitled to claim general damages that it can prove.

Lamont Project & Construction Lawyers

Our Team have the industry knowledge and experience to assist both Principals and Contractors in all major projects and contractual drafting and contractual disputes. If you would like to discuss any matters raised in the above article or this 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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