An Introduction to Liquidated Damages
Introduction
Liquidated damages (often referred to as “LDs”) are also known as liquidated and ascertained damages (referred to as “LADs”) or delay damages. All three are the same thing.
They are common in construction and engineering contractse. They can be used to compensate a party for specific breaches of contract by the other party, and are mostly used to compensate delays to project completion.
Below, Hamshaw outlines what LDs are, why they are used, and their practical implications for contractors, employers, and subcontractors.
What Are Liquidated Damages and Why Are They Used?
LDs are sums agreed upon by parties to be paid in the event of specific breaches of contract. Unlike general damages, which are calculated by reference to (and require proof of) the actual loss that arises from the breach(es), LDs provide a fixed amount (or a pre-agreed formula for calculating a fixed amount) of compensation.
In other words, instead of a party having to prove that a breach has occurred, and then prove the financial consequences of that breach (i.e. general damages), LDs are pre-agreed so that the party only has to prove that a breach has occurred and not what the specific financial consequences are.
An LDs clause might provide, for example, that a contractor will be required to pay £1,000 per week for every week of delay, or it might provide that a contractor will be required to pay 1% of the contract price for every month of delay.
The primary benefit of using LDs is to offer certainty and reduce or avoid (often lengthy, and complex) arguments over the calculation damages. In construction where delays are common and proving actual losses arising from delays can be challenging.
It is not only unecessary to prove the actual amount of loss when claiming liquidated damages, but it is also unecessary to prove the existence of any loss. Providing there has been a relevant breach, it is possible for a party to recover LDs even when it is obvious that the party has not suffered any loss at all as a result of the breach.
LDs typically apply to delays in completing construction works but can also address other breaches such as performance standard failures.
The party entitled to LDs is normally that party that is comissioning the works. For example, it would be the employer (in a contract between an employer and a main contractor) or a main contractor (in a sub-contract between a main contractor and a sub-contractor).
Are LDs an Exhaustive Remedy?
LDs are often intended as an exhaustive remedy for specific breaches, particularly delays. If the contract specifies LDs for delayed completion, this generally prevents a claim for both the LDS and addition, general, damages for the same breach.
Benefits of LDs Clauses
Certainty: LDs provide clear expectations for both parties regarding the financial consequences of delays or other relevant breaches. This allows the more accurate pricing of risk.
Limits Contractor's Liability: LDs typically limit the contractor's financial exposure to the pre-agreed amount, offering protection against more extensive financial claims. In addition, many LDs clauses will impose a cap on the total amount of LDs that the contractor might have to pay.
Saves Time and Legal Fees: Disputes over the correct calculation of general damages can be costly and time-consuming. LDs allow employers to recover a fixed amount without needing to prove specific losses, reducing legal expenses.
Deterrent to Breach: LDs clauses can act as a commercial incentive for contractors to meet deadlines or performance obligations, encouraging compliance with the contract terms.
Can LDs be Avoided?
Aside from avoiding the breach in the first place, there are several ways in which LDs clauses might be challenged:
Out of Scope: The contractor may argue that the specific breach does not fall within the LDs clause (i.e. that the LDs are not triggered by the specific breach)
Uncertainty: An LDs clause that is vague or lacks clear terms may be deemed unenforceable. However, the court will generally look to enforce LDs clauses where possible, so the uncertainty in the clause will have to be significant before the clause will be considered invalid.
Preconditions: the LDs clause might contain pre-conditions that require one or both parties to take certain steps before the LDs are triggered. These might include, for example, the employer giving a notice to the contractor which permits the contractor to fix the breach (e.g. to recover the delay) within a certain period of time. If a party fails to meet any procedural conditions provided for by the contract, the right to claim LDs might not crystallize.
LDs Clause is a Penalty: A contractor may argue that the LDs clause is a penalty rather than compensation, especially if the amount is disproportionate to the actual loss suffered by the employer. This is explored further in the section below.
LDs Clauses As Penalties
The distinction between LDs (which are enforceable) and penalty clauses (which may not be) is crucial. The court has developed guidelines to determine whether an LDs clause is a penalty.
Historically, the test focused on whether the LDs represented a "genuine pre-estimate of loss” arising from the breach.
Modern case law, however, introduces additional factors. The court now considers whether the LDs clause imposes a disproportionate detriment on the contractor relative to the employer's legitimate interest in enforcing the contract.
LDs and Sectional Completion / Partial Possession
Issues can arise when construction contracts involve sectional completion or partial possession. The LDs clause must account for these scenarios, clearly stipulating how the damages will be calculated for different sections or when parts of the works are taken over early by the employer. If it does not do so, then the LDs clause could fail to operate effectively (or at all).
What Happens if an LDs Clause is Unenforceable?
If an LDs clause is found to be unenforceable, the employer may pursue a claim for general damages, unless the contract contains an exclusive remedies clause. Whilst claiming general damages is more challenging, requiring proof of actual loss and possibly mitigation efforts, it may result in recovery of a larger sum in damages than if the LDs clause had been enforceable.
Conclusion
LDs clauses play a vital role in construction and engineering contracts by providing certainty, limiting liability, and saving time and costs. Whilst they are generally enforceable, it may be possible to successfully avoid them particularly when they are poorly drafted or provides for LDs that are grossly excessive. It is crucial for both employers and contractors to ensure LDsclauses are clear, fair, and based on anb auditable and reasonable estimate of potential losses.
If you require help drafting, acting upon, or avoiding an LDs clause, contact Hamshaw today.