Liquidated damages clauses are a way of calculating what compensation a party will owe the other pay, if it is in breach of its obligations. Allowing a party to claim compensation for loss or damage that occurs as a result of the other party’s failure to deliver the works, goods or services under the contract on time.
They are identified damages whose amount the parties agree upon during the drafting of a contract for the non-defaulting party to receive as compensation upon a specific breach. Unlike general damages that are determined by a court, liquidated damages are fixed amounts.
Delay of the contractor is a common example of liquidated damages clause. For instance, parties may agree in the contract that the contractor will owe the principal $2500 in damages for each day of delay.
When forming a construction contract it is imperative to understand what is meant by the term ‘liquidated damages’. Particularly, if you find yourself in the position of being the party in breach under a contract. Moreover, if you are forming a construction contract you should be careful to ensure that the liquidated damages clauses do not impose penalties but rather compensation.
The Purpose of Liquidated Damages Clauses
Including liquidated damages clauses in a contract serves to incentivise each party to complete their obligations under the contract on time. As well as preventing the unreasonable disadvantaging of non-defaulting parties due to breaches of the other party.
Moreover, they offer a degree of certainty for all parties as to what will happen should a breach materialise. Hence, they are useful as they proactively provide resolutions to potential conflicts that may arise such as delays.
It allows the principal to recover their loss without having to prove actual loss. Additionally, liquidated damages clauses cap the contractors liability for damages at a fixed amount. A valid liquidated damages clause will fix the amount recoverable without the need for costly litigation.
Enforceability
Indeed, the parties will typically agree to the liquidated damages that will be included in the signed contract. Hence, if needed, a court will enforce the provision the same as a contractual term. Although, there are limits on the enforceability of liquidated damages clauses.
A court will not enforce a liquidated damage clause that imposes a penalty on the breaching party. Hence, the damages specified must represent a genuine pre-estimate of loss that the non-defaulting party is likely to suffer due to the other party’s breach.
Courts highly recommend that the liquidated damages clause includes a formula. A formula for calculating the damages at fixed intervals i.e daily. Unless the circumstances easily allow for it, designating lump sum amounts should be avoided.
Liquidated damages vs. Penalties
It is important to understand the distinction between liquidated damages and penalties. The court will not enforce a liquidated damage clause if they consider it to amount to a penalty. A liquidated damages clause is a genuine pre-estimate of loss or damage that a non-defaulting party may sustain if the breach materialises. While a penalty clause imposes an amount that operates as a punishment; or does not legitimately protect the commercial interests of the non-defaulting party.
The title of the clause is irrelevant, the court will rather consider whether in substance it is a penalty. The court will adopt a case by case basis approach in determining whether a liquidated damages clause is a penalty. As it is generally dependent on the build and the contract.
However, there are key tests that the court has traditionally considered when deciding whether a contractual provision exceeds these damages. These key considerations are:
- Is the amount provided for in the clause ‘extravagant and unconscionable’ when compared with the greatest possible loss that could possibly be shown to result from the particular breach of contract?
- Does the breach consist solely of non-payment of money which results in a larger sum for damages being required?
- Does the clause stipulate the same amount is to be paid for different breaches, even if the breaches vary in terms of seriousness?
The court will likely find that the clause is a penalty, if the answer to any of these questions is in the affirmative. Consequently, it will not be enforceable.
Indeed, the main consideration is whether the liquidated amount is extravagant. For example, a liquidated damages clause may be acceptable even where the actual loss a party may suffer cannot be properly estimated; as long as the amount is not extravagant.
Key Takeaway
A liquidated damages clause in a construction contract addresses what consequences will flow from a breach of contract. Thereby, providing mechanisms that allow a party to claim compensation for loss or damage that occurs as a result of the other party’s failure.
The court will not enforce a clause that imposes penalties. Therefore, be sure that the fixed amount is a genuine pre-estimate of loss or damage; that a non-defaulting party may sustain if the breach materialises. Ensuring the amount is not extravagant.
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Phil is a director at OpenLegal. He has over 16 years experience working in private practice and in-house counsel in Sydney and London, giving him expertise in employment law, IP, finance, leases, dispute resolution, insurance and contracts.
Raymond is a legal intern at OpenLegal, working with our legal content team. He is currently a penultimate student at the University of Technology Sydney, studying a Juris Doctor degree with an undergraduate Bachelor of Global Studies. He is particularly interested in Intellectual Property law and the increasing internationalisation of that area of business.
