Liquidated damages is a term used to describe a specific dollar amount of loss that is predetermined and calculated before any loss is actually incurred. The term is often used in construction contracts to encourage contractors to complete their work on time, but it is also used in other contexts an industries.
If you are considering signing a contract that includes liquidated damages, you need to be careful.
This article explains what liquidated damages are, how they can benefit you, and how they can harm your business.
Author: Farrah Motley, Legal Principal of Prosper Law and an Australian qualified legal practitioner.
What is the legal meaning of liquidated damages?
Liquidated damages refers to loss incurred by a party which has been predetermined and is an obligation which is easily convertible into cash. Liquidated damages can be compared to general damages where the amount must be determined by a Court judgement based on legal principles.
Commercial contracts may include a liquidated damages clause as a way of dealing with the possibility of a breach by a party. A liquidated damages clause means that a party in breach of its obligations under a contract must pay a particular dollar amount to compensate the other party for that breach. The dollar amount is transparent, fixed and set out in the contract.
The nature of performance liquidated damages means that the dollar amount of liquidated damages will depend on what has been promised by the party agreeing to pay the liquidated damages. For example efficiency, output or availability.
Liquidated damages for delay
Liquidated damages are often - but not always - used in the context of construction projects. Where the successful performance of a contract (for example, the construction of a building) is highly reliant on time and completion by a particular date, projects must keep to a strict program. If that completion date is not met, the client can suffer significant loss.
Examples off loss which may be suffered because contractual timeframes are not met include:
unable to meet settlement dates for the sale of property
increased overheads to manage the project, such as staff costs
unable to meet customer demand for goods and services
having to pay increased fees to other impacted contractor
Liquidated damages for underperformance
Liquidated damages may not only apply to the failure by a party to meet a time frame. A predetermined amount of loss may also apply to specific instances where a party has failed to meet their contractual promises. This may include a failure by a contracting party to meet a particular level of output or efficiency.
For example, if a manufacturer has failed to ensure that a batch of goods to be on-sold to customers is of merchantable quality, a liquidated damage clause may apply in relation to that batch.
The rationale is that the client, in anticipation of loss it will suffer as a result of having no goods to sell to its customer, sets an amount for damages that will be imposed once the poor quality batch has been determined.
Types of contracts which may include liquidated damages
Construction contracts: Liquidated damages most often appear in construction contracts. Construction projects are time sensitive and costly if they run over time.
Employment contracts: Liquidated damages clause can arise in employment contracts, but they are not used often. No surprise that not many prospective employees would agree to pay liquidated damages!
IT development contracts: Similar to a construction contract, the completion of IT services or the supply of IT goods can be critical for some businesses. For that reason, it is not uncommon to find liquidated damages clauses in IT contracts.
IT contracts, including the installation of hardware and software, and IT consulting services, are becoming more critical to business operations. If IT systems are down, businesses can suffer significant loss from lack of productivity.
Outsourcing contracts: In an outsourcing contract, liquidated damages can take the form of service credits. These credits reduce the amount payable by the client if service standards are not met.
Why do liquidated damages need to be calculated?
In general and in a commercial setting, Australian Courts respect 'freedom of contract' and that parties have a right to agree to the terms of engagement and risk allocation between themselves, without Court intervention.
However, if you pluck an amount out of thin air and label it an amount for 'liquidated damages', you may find your opponent having a valid argument that your liquidated damages clause is a penalty. If a liquidated damages clause is a penalty, it is unenforceable. If it is unenforceable, it's inclusion in a contract is pointless.
A penalty has been defined by case law (law made by judges). Below is some of the guidance given by the Courts as to when a liquidated damages clause will be considered a penalty (and be struck from the contract):
the amount is “extravagant and unconscionable”, and “out of all proportion” when compared to the greatest loss possible from a breach
the breach is the non-payment of an amount of money and the rate of liquidated damages amount is greater than the payment amount would have been
the same sum is payable for breaches of varying degrees of seriousness
The law of penalties seeks to ensure that the person claiming the benefit of the clause cannot claim an amount which bears no relationship to the loss they may actually suffer.
How can liquidated damages be estimated?
To avoid a liquidated damages clause being considered a penalty, you need to ensure:
the clause includes a formula which describes how the amount will accrue (for instance $1,000 per day (or, even better, a formula for how the rate is made up) x each day/business day the breach continues)
the calculation is made before the relevant contract is entered into;
the losses you are including in your calculation are ones that would arise due to the contractor failing to either complete the work by a specified date, perform efficiently or provide a certain output;
the you have applied some thought and carefully considered what your actual losses would be if your supplier were to breach their promise;
that you do not arbitrarily use the same liquidated damages rate in standard contracts used for different projects and suppliers;
that you do not specify a sum that is "extravagant and unconscionable" in comparison to the greatest conceivable loss;
that you avoid a clause where the breach solely relates to the non-payment of money and it set out a large amount for liquidated damages;
that you ensure that different amounts are payable for different breaches of varying degrees of seriousness.
There are no specific rules or set method or any to follow in calculating liquidated damages. If you generally follow the legal principles and Common Law regarding the law of penalties, you should take confidence that the liquidated damages clause is enforceable.
Set out below are some examples of costs that could be included in building up the liquidated damages rate:
additional rent that needs to be paid because of the time overrun
storage costs as a result of needing to store goods (furniture, stock, etc.) because you cannot relocate back to site
administration or staff supervision costs
cost of extending insurance periods
financing costs, including interest on loans
loss of net profit
Once you have totaled up those costs, you should then work out what the net present value of that amount is. Net present value is a finance term which acknowledges that money you receive today is worth more than money you receive at a future point in time. This becomes relevant where, for example, your cost build up includes amounts for loss of future net profit.
To simplify, $100 today is worth more than $100 you receive next year.
A net present value calculation will discount the total costs to take into account the time-value benefit to the recipient of the payment.
It's all very well going to great lengths to build up the cost to demonstrate it was a genuine pre-estimate of loss, but you need to make sure you keep records that you went through this exercise. The rule - keep detailed records and keep them somewhere safe and easily accessible.
How can liquidated damages benefit you?
No obligation to mitigate loss
Unlike claiming general damages at law, charging liquidated damages does not require you to mitigate your loss. This means that you don't to try and avoid or reduce the amount of loss that you are or may suffer. This is great if you are the client. However, in practice it is - of course - still in your interest to attempt to limit the amount of loss you are incurring. After all, you may still receive the same amount in liquidated damages and the net result will be that you are better off overall.
Agreed in a low-conflict setting
Liquidated damages clauses are agreed at the beginning of a business relationship and/or project. When the parties enter into the relevant contract, they are likely to be in the 'honeymoon' phase of their relationship and cooperating with one another. There is nothing foreseen that could cause delay (otherwise it would have been factored into the completion date). And, because the supplier wants to win the job and is happy to stand behind their word that they are timely, efficient or provide a quality product, they happily sign up to liquidated damages.
Everyone knows exactly what the cost of compensation will be if those promises are not met; there are no surprises.
The alternative is that there is no liquidated damages clause and either:
the parties have to try to reach an agreement as to the amount of loss incurred (in a high-conflict setting); or
the parties have to spend a considerable amount of money for a Court to determine the amount of loss incurred.
Liquidated damages can encourage a party to keep their contractual promises and deter them from breaking those promises.
Until liquidated damages are actually charged, they act as encouragement to the supplier to carry out their promise to the buyer. Once the promise is broken (for instance, the time frame has not been met), liquidated damages encourage the supplier to act fast to rectify the breach of contract.
Liquidated damages clause have the potential to benefit both parties. This is because the amount of reimbursement for losses is transparent. Everyone knows what they are in for if things don't go to plan.
How can liquidated damages harm your business?
Agreeing to a liquidated damages clause in a contract (if you are the supplier) has the potential to cause issues when it comes to insurance. This is because some policies of insurance may explicitly exclude liquidated damages or delay damages from the insurance coverage. However, in some instances you can purchase an "endorsement" (which is an extension to the coverage of the insurance) for liquidated damages that you may become liable to pay.
You need to assess whether the additional insurance premium you will need to pay is worth paying, when compared to the likelihood and cost of liquidated damages being imposed on you.
Matters outside your business's control
Sometimes, things just happen. You have no control over them and couldn't have stopped them from happening by taking reasonable steps.
If you are a supplier and have agreed to pay liquidated damages, you need to be careful that you are only obliged to pay the rate for delay, inefficiency or poor output where the issue has arisen because of something you have done wrong. The last thing you want is to be required to pay liquidated damages for matters caused by your client or their other suppliers.
Potential for Court proceedings
Regardless of whether the liquidated damages clause is watertight or not, they are frequently a source of challenge. The risk of Court proceedings will increase as the amount of liquidated damages increases.
Challenging a liquidated damages clause in Court can be an expensive process. But it may be worthwhile if the rate and amount payable is significant.
If a liquidated damages clause is challenged in Court, the onus will be:
on the supplier to prove (on the balance of probabilities) that the clause is a penalty; and
on the client to defend the clause on the basis that it does represent a genuine pre-estimate of loss.
How to Draft a Liquidated Damages Clause
If you are the client
calculate your losses to figure out the rate;
make sure it is crystal clear what the trigger is for payment of liquidated damages. For instance, identify the specific date for completion, the measurable efficiency or output requirement;
how to identify when the breach has stopped. For instance, a certificate of practical completion, notice to the supplier that the efficiency or output requirement has been met; and
make sure you can still recover general damages (for instance, as a fall back in case the liquidated damages clause is determined to be unenforceable).
If you are the supplier
put a limit on the total amount of liquidated damages you may have to pay;
ensure liquidated damages are the only remedy available to your client; and
make sure you can recover liquidated damages from your suppliers that have contributed to the breach.
Case Law Examples of Liquidated Damages Disputes
Grocon Constructors (Qld) Pty Ltd v Juniper Developer: Grocon (the builder) sued Juniper for unpaid work and delay costs. Juniper counterclaimed for liquidated damages.
Grocon and Juniper's contract contained a liquidated damages clause which was triggered if Grocon failed to achieve practical completion by the relevant date for each part of the project. Practical completion included minor defects. The liquidated damages clause set out a rate which increased over time and changed to each part of the project.
Grocon argued the clause was a penalty because:
it imposed substantial payment requirements on Grocon for trivial breaches that were not proportionate to Juniper’s loss; and
it required payment of the same lump sum for events of varying significance.
Juniper, on the other hand, argued:
the clause was not a penalty because the amount of damages was not extravagant or unconscionable when compared to the greatest loss possible;
it could not settle the sales contract and provide possession of the property until practical completion; and
the clause did not operate for a variety of events.
Juniper's argument won. The Court determined that the liquidated damages clause was not a penalty because it was not “extravagant or unconscionable in amount”, or out of all proportion, rather than only lacking in proportion. Further, the case was not one where a breach could occur many times and in different ways with different consequences for each breach.
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Farrah Motley | Legal Principal
PROSPER LAW - A Commercial Law Firm for Businesses
M: 0422 721 121