Liquidated damages are an agreed contractual rate of amounts payable by a party who delivers a project late.
The upside of liquidated damages is that the fixed rate provides the parties with certainty. That is:
- a liquidated damages rate is determined at the time the contract is entered into (as opposed to general damages that are calculated at the time of the breach of the contract);
- from contract execution, the Contractor has a clear understanding of its liability for late completion of the project; and
- from contract execution, the Principal can use a simplified method of calculating loss arising from late completion (without stepping through the hoops of causation, remoteness and mitigation that is necessary when seeking general damages).
However, this does not mean that it is open season for the Principal when it comes to inserting a liquidated damages rate into the contract. Rather, the courts have sought to limit any such behavior by making liquidated damages subject to the doctrine of penalties. If a court determines that a liquidated damages clause is a penalty, it will be unenforceable.
This begs the question – when are liquidated damages a penalty?
A Genuine Pre-Estimate
The fundamental test is that the party levying liquidated damages is required to show that the rate of liquidated damages agreed between the parties was a genuine pre-estimate of loss.
Critically, whether the liquidated damages rate is a genuine pre-estimate of loss (and therefore not a penalty) is to be determined at the time the parties entered into the contract. It is a decision, therefore, that does not have the benefit of hindsight in assessing whether or not it was “genuine”.
If the Court determines that the liquidated damages clause is a genuine pre-estimate of loss then the liquidated damages clause will likely be enforceable.
Given this, it is very important to make sure you take time to negotiate the liquidated damages rate to be able to say with confidence that it is a genuine pre-estimate of loss. The pre-estimate of loss may be high, and it may even turn out to be inaccurate, however of paramount importance is that the pre-estimate of loss is genuine.
Extravagant or Unconscionable?
In practical terms, the court will also be considering if the amount payable is either:
- extravagant; or
- unconscionable,
in comparison to the greatest loss that could be expected.
So, if the court finds that the amount specified in the contract is extravagant or unconscionable, it is unlikely to be a genuine pre-estimate of loss and therefore may be found an unenforceable penalty.
A Case Study on Liquidated Damages as a Penalty
The principle is best illustrated by a case example.
State of Tasmania v Leighton Contractors Pty Ltd – not a penalty
In June 1999, the State of Tasmania and Leighton Contractors Pty Ltd (Leighton) entered into a project deed for Leighton to design, construct and maintain 13.65 kilometres of new highway, to be incorporated into the Bass Highway.
The contract included a provision for liquidated damages to be calculated at the rate of $8,000 per day.
When construction was not completed by the stipulated date, $1,832,000 was deducted as liquidated damages by the State (calculated at a rate of $8000 per day).
The court was asked to decide whether the rate stipulated was a legitimate liquidated damage or a penalty.
Initially a single Judge found that the amount was a penalty and not enforceable. However, the Full Court on appeal held that the liquidated damages rate of $8000 per day was not a penalty, noting:
- the liquidated damages rate was not chosen arbitrarily and the figures were adjusted to justify the amount selected;
- the State had negotiated the contract with a large corporation that was well experienced in work of the nature of the contract; and
- the contract itself provided for the expenditure of public money amounting to over $30m, and the State had a responsibility to be accountable for how public money was spent. Therefore, the State was entitled to require reasonable compensation for:
- delay suffered; and
- inability of the public to use the infrastructure in question.
In other words, the Courts accepted that the parties had determined, and each agreed to, a liquidated damages rate that reflected a genuine pre-estimate of loss that the State would incur if Leighton Contractors was late in achieving practical completion by the date for practical completion.
Therefore, even though $8,000 per day may seem steep on paper (especially calculated over the entire period in question), the Court found that it was a genuine pre-estimate of loss and therefore, the State was entitled to enforce the liquidated damages rate in seeking to recover its losses.
As you can see – it was irrelevant whether or not the State had, in fact, suffered that damage or even any damage. All that mattered was the application of the relevant test to the liquidated damages clause.
Certainty is Good
Parties often agree to include a liquidated damages clause so that they can insert a rate in the contract that subsequently affords them a simple process for calculating:
- how much the Contractor is liable to pay should it be late in achieving practical completion; and
- how much the Principal is entitled to recover if the Contractor is late in achieving practical completion.
In other words, the inclusion of a liquidated damages clause can afford the parties certainty.
For a contractor, of course you want the potential liquidated damages to be as limited as possible. In negotiations, consider not just whether or not the periodic rate itself is a reasonable pre-estimate of loss in the hands of the Principal, but also whether it should be capped at either an absolute figure or a percentage of the contract sum. This should also flow through to your contract administration on your various active projects – where are the risks higher or lower for liquidated damages, and how are you managing those risks throughout contract delivery?
Of course, as a Principal you want to ensure that you have some visibility on your possible exposure to loss in the event the project is late, and utilise available information to ensure that your liquidated damages clause is a genuine pre-estimate of those losses. Meaningful contract negotiations can play an important role in establishing this, as can keeping good records of the considerations involved in selecting the relevant sum that is ultimately agreed.
If you need assistance with negotiating your liquidated damages clause, please contact our construction and infrastructure team.
