15 Jul 2014, by Brett Saal at Saal & Associates Lawyers
Most contracts include a provision that allows one party to claim liquidated damages if the works are not completed on time. Even contracts for the construction of domestic homes contain this provision. However, the concept of liquidated damages is not well understood. Often, an amount is included in a contract with little or no thought as to what it means. This article proposes to provide some guidance for considering liquidated damages clauses.
If the builder does not complete the work on time (generally this means reaching practical completion), the owner/head contractor is entitled to recover any loss that he suffers because the work was not completed on time. This is usually referred to as general damages. In a commercial context, computing the amount of the loss can be difficult, e.g. were there any extra overheads incurred and if so, what percentage can be attributable to the fact that the work was not completed on time? Perhaps more importantly, obtaining the evidence to prove the amount of the loss can be time consuming and difficult. If the loss came from twenty different sources, then twenty people have to be called as witnesses and documents obtained from all of them.
The provision of a clause for Liquidated damages is the means by which a party gets around having to prove the loss he has suffered. By providing for an amount of liquidated damages, the innocent party can simply claim that amount multiplied by the number of days that the project has gone over time.
The definition of liquidated damages is that it must be an amount agreed by the parties to be a genuine pre-estimate of the loss that the innocent party will suffer if the work is not completed on time.
There is no requirement that the estimate has to be accurate. It may be significantly more than the actual loss or it may be significantly less than the actual loss. The only requirement is that it be a genuine estimate.
The limitation on liquidated damages is that the amount must not be so high that it becomes a penalty. A liquidated damages clause becomes a penalty if its purpose is to operate “in terrorem”, i.e. to induce performance of the contract or as a punishment for default that is out of proportion with the loss that is actually suffered. A clause that is a penalty is unenforceable, although the innocent party may still be able to claim general damages. A detailed analysis of penalty provisions is beyond the scope of this article.
As with almost every contract situation, there is no one complete answer. Each contract has to be construed as a whole. However, generally if a contract provides for liquidated damages, then the party entitled to the liquidated damages can recover only the amount of liquidated damages and not general damages. If the estimate of liquidated damages is too low and does not cover his actual loss, then he is stuck with that loss.
For a party to include “N/A” (presumably “not applicable”) or “nil” as the amount of liquidated damages payable is dangerous. Again, the law regarding these issues is beyond the scope of this article. However, there is a risk that using these terms, particularly “nil” will mean that there are not liquidated damages payable and that that was the estimate of damages the parties had agreed to, i.e. the innocent party is not entitled to any damages at all.
A contractor who will have the benefit of a liquidated damages clause should actually engage in the calculation of its likely loss should any particular subcontractor fail to complete its work on time. The process of reasoning and calculation should be documented. This will ensure that he has evidence that he can provide a subcontractor, or more importantly the Court, should the estimate of damages be called into question, i.e. usually if it is alleged to be a penalty.
What extra costs will be incurred by a contractor will differ from case to case and contract to contract. Some losses could include:-
What you should not do is simply arbitrarily (i.e. essentially pluck a figure out of the air) decide the amount that is to be included. Nor can one simply apportion the amount of liquidated damages that you might suffer under your head contract between the various subcontractors. In our view, that is not a genuine pre-estimate of the loss that would be suffered should any particular subcontractor not complete its work on time.
The first thing you must do is negotiate the amount before signing the contract. Once the contract is signed, prima facie, both parties have agreed that the amount of liquidated damages is a genuine pre-estimate of the loss the party will suffer. The time to agree as to the amount of liquidated damages for which you may be liable is before signing the contract.
If you have any concerns over the amount specified as liquidated damages, you should request the other party to provide you with any documents and its calculations as to how the amount has been calculated. This is the only true way in which you can adequately assess whether the proposed amount is a genuine estimate of the loss that that party is likely to suffer. If the other party has in fact undertaken the exercise of estimating its loss, it should have no concerns in providing them to you so that there can be true agreement as to the amount to be included in the contract.
What you should not do is sign a contract without giving any consideration as to the amount of liquidated damages for which you may be become liable. Furthermore, good contract administration, especially in relation to extensions of time is essential in avoiding a situation in which you might become liable for liquidated damages.