A liquidated damages clause is a useful way to deal with the possibility of breach under a contract. The clause dictates that a party in breach of a contract is obliged to pay a sum in compensation for the breach. The sum is fixed and written into a contract.
Liquidated damages clauses can be found in a range of contracts, but are commonly used in construction contracts, especially to deal with delays. On a construction project, if completion is delayed due to a contractor’s breach, the contractor is liable to pay the contracting party (the principal) a specific sum for each time period of the delay. This article will focus on liquidated damages in this context.
Courts generally uphold a liquidated damages clause on the basis of the principle of freedom of contract, but if the court determines the clause to be a penalty, the clause will not be enforceable.
Advantages of a liquidated damages clause
When a contract contains a liquidated damages clause, each party is incentivised to adhere to their contractual obligations. Advantages of such a clause include:
- parties being spared the time and expense of dispute resolution and/or court action in the event of a breach;
- the principal not having to establish elements of a claim such as actual loss, mitigation or causation;
- a degree of certainty to insurers about the risks of a project;
- the benefit of being able to deal with minor breaches in a long-term contract, thereby allowing parties to continue a commercial relationship;
- the contractor having an opportunity to manage project risk by placing an overall cap on liquidated damages, such as 5% of the overall contract price, or by restricting a remedy to liquidated damages.
There are several key components of a liquidated damages clause, all related to practical completion.
This is a critical term in a clause for liquidated damages. It means each major stage has been finalised except for minor omissions or defects which do not prevent the structure from being used and can be rectified without inconvenience to the user. It is imperative that the requirements for practical completion are clear and can be objectively assessed.
Date for practical completion
This is the date by which the contractor has promised practical completion. It may be a fixed date, a fixed number of days from the contract date, or triggered by a specific event. The date for practical completion must be clear, or the process to determine the date must be obvious or use an easily recognised event.
Date of practical completion
This is the date practical completion is actually reached and there must be some form of proof that practical completion has been reached, such as notice to a party or a building surveyor’s certificate.
The rate of liquidated damages is usually specified as a fixed sum per time period, which is payable between the date for practical completion and the date of actual completion.
A liquidated damages clause as a penalty
The key consideration in a liquidated damages clause is whether the sum specified amounts to a penalty. If the court finds that the clause imposes a penalty on the party in breach, the court will not enforce the clause. The sum must represent a genuine estimate of the loss a party will likely suffer as a result of a breach by the other party. The clause should include a formula for calculating damages, accruing at fixed intervals. The amount should not be a lump sum unless the circumstances allow the parties to easily calculate an accurate amount.
The purpose of the rule is to ensure the claimant cannot claim a sum of money or other remedy which has little or no relation to the loss suffered.
Case law shows a liquidated damages clause will be a penalty if:
- the sum is “extravagant and unconscionable”, and “out of all proportion” when compared to the greatest loss possible from a breach;
- the breach is solely for the non-payment of a sum of money and the liquidated damages amount is greater than the payment amount would have been;
- the same sum is payable for breaches of varying degrees of seriousness.
Grocon Constructors (Qld) Pty Ltd v Juniper Developer
This Queensland Supreme Court case was important in establishing principles for assessing the enforceability of a liquidated damages clause. In that case, Juniper contracted Grocon to build a four-part development. Grocon sued Juniper for unpaid work and delay costs, and Juniper countersued for liquidated damages.
The liquidated damages clause was triggered by Grocon failing to reach practical completion by the specified date under each part of the project. Practical completion included minor and trivial defects such as replacing defective light globes, professional cleaning and the removal of all rubbish and equipment. The clause provided for a rate of damages that increased over time and differed for 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;
- it required payment of a single lump sum for each of a variety of events of varying significance.
- 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;
- the clause did not operate for a variety of events.
The court agreed with Juniper that the liquidated damages clause was not a penalty and that for it to be a penalty, the clause must be judged “extravagant or unconscionable in amount”, or out of all proportion, rather than only lacking in proportion. It also determined that the case was not one where a breach could occur many times and in different ways with different consequences for each breach.
For advice or representation in any legal matter, please contact Armstrong Legal.