Liquidated damages are a predetermined amount of loss. It calculates a specific amount of loss before incurring any loss.
People often use the term in construction contracts. Liquidated damages can motivate contractors to finish their work promptly. They are also used in various other contexts and industries.
If you are considering signing a contract that includes liquidated damages, you must be careful.
This article explains what liquidated damages are, how they can benefit you, and how they harm your business.
Liquidated damages refer to loss incurred by a party that has been predetermined and is an obligation that 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 LDs. For example efficiency, output or availability.
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 the team does not meet the completion date, the client may experience significant loss.
Examples of loss that may be suffered because contractual timeframes are not met include:
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 to that batch.
The rationale is that the client sets an amount for damages that will be imposed once the poor-quality batch has been determined. This is in anticipation of the loss it will suffer as a result of having no goods to sell to its customer
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 clauses 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 losses from a lack of productivity.
Outsourcing contracts: In an outsourcing contract, damages can take the form of service credits. These credits reduce the amount payable by the client if service standards are not met.
Australian Courts respect ‘freedom of contract’. The Court believes that parties should be able to agree on their own terms and responsibilities without interference from the Court.
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, its inclusion in a contract is pointless.
Case law (law made by judges) has defined a penalty. 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 law of penalties ensures that a person can’t claim an amount that doesn’t match the loss they may suffer.
To avoid a liquidated damages clause being considered a penalty, you need to ensure:
There are no specific rules or set methods 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:
Once you have totalled up those costs, you should then work out what the net present value of that amount is. Net present value is a finance term that acknowledges that money you receive today is worth more than the 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.
Unlike claiming general damages at law, charging LDs does not require you to mitigate your loss. This means that you don’t need 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 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.
Liquidated damages clauses are agreed upon 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.
There is nothing foreseen that could cause a 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 for 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:
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 clauses 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.
If you agree to a liquidated damages clause in a contract as a supplier, it could create problems with insurance coverage. 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”. This may extend your insurance coverage to include liquidated damages you may have 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 LDs being imposed on you.
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. Ensure that you must only pay the rate for delay or poor output where the issue has been caused by you. The last thing you want is to be required to pay liquidated damages for matters caused by your client or their other suppliers.
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 LDs increases.
Challenging a liquidated damages clause in Court can be an expensive process. But it may be worthwhile if the rate and amount payable are significant.
If a liquidated damages clause is challenged in Court, the onus will be:
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 clause for liquidated damages. The clause would trigger 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 that increased over time and changed for each part of the project.
Grocon argued the clause was a penalty because:
Juniper, on the other hand, argued:
Juniper’s argument won. The Court determined that the 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.
Probuild, a construction company, entered administration in 2022. Before this company ceased to exist, it was in a dispute with Shade Systems.
Shade issued a payment claim to Probuild for $324,334. This payment related to the supply and installation of external louvers at an apartment building.
Probuild rejected Shade’s claim. Probuild said that Shade owed $1,089,900 in liquidated damages from Shade. The adjudicator awarded $277,755 to Shade under the Security of Payments Act. The adjudicator denied Probuild’s claim for liquidated damages.
The matter went to the NSW Supreme Court, then the Court of Appeal and ultimately the High Court of Australia. In the end, the Court found in favour of Shade.
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