What do liquidated damages clauses in construction contracts mean?
A liquidated damages clause provides pre-determined and fixed monetary compensation for a proven or admitted breach of contract. It is unnecessary to prove loss as a result of the breach to receive liquidated damages.
By contrast, unliquidated damages, which are available at common law, are determined by the Court with reference to the loss suffered.
While liquidated damages are found in many contracts, such as employment and outsourcing contracts, they are common in construction contracts.
In construction contracts, liquidated damages clauses often apply when the contractor has not completed the work by a certain date. For example, the contractor may be liable to pay a daily rate to the principal for each day that the work is delayed.
Benefits of liquidated damages clauses
Liquidated damages clauses are popular in construction contracts for several reasons:
- They can provide the principal greater certainty that the terms of the contract will be adhered to by providing added incentive to the contractor.
- They also give the contractor certainty by capping liability for a breach (although to exclude general damages available at common law requires clear drafting).
- They enable the contractor to factor in their liability for a breach when negotiating the contract price.
- They also enable the contractor to weigh up the cost of a breach against the cost of expending more resources to avoid a breach.
- The principal is not under any obligation to mitigate the loss, as they are in a common law claim.
- Seeking common law unliquidated damages often requires time-consuming and costly litigation.
- Unliquidated damages require the principal to prove their loss with evidence which is often difficult to quantify and similarly time-consuming.
Dangers of liquidated damages clauses
Courts will not enforce liquidated damages clauses which they interpret as penalties.
A clause will be deemed a penalty when the pre-determined compensation is ‘out of all proportion’ (disproportionate) to the principal’s legitimate interests (including business and financial interests) that the clause is designed to protect. The test does not restrict the Court to considering only losses caused directly from the breach, the broader impact of the breach may be considered.
Effect of ‘Nil’ or ‘N/A’
Case law in Australia indicates that giving the amount of ‘zero’, ‘nil’, ‘N/A’ damages in a liquidated damages clause will not preclude the principal from their right to unliquidated damages at common law. If the parties intend to provide no entitlement to liquidated or unliquidated damages, this will need to clearly expressed in the contract.
Liquidated damages clauses provide fixed, pre-determined monetary compensation for a breach of contract. They are beneficial in removing the cost and time expended in litigation. However, the benefits to liquidated damages clauses can be lost without clear and considered drafting, particularly if they are considered by the Courts to be a penalty clause.
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