The bane of every contractor is the liquidated damages clause. Liquidated damages are a massive stick in the hands of your principal that can quickly cripple the profitability of your job and sour a commercial relationship.
In this guide we’re going to show you:
- what liquidated damages are;
- why liquidated damages clauses are commonplace in construction contracts;
- an example liquidated damages clause;
- an explanation of the four key elements that influence when liquidated damages apply;
- the circumstances in which liquidated damages might be considered an unenforceable penalty;
- how contractors can try to negotiate about the liquidated damages clauses; and
- the intersection between extensions of time and liquidated damages.
By the end, you’ll have a thorough understanding of how to navigate the LD clause in your next contract, from negotiation through to project delivery.
So grab a cup of coffee, and let’s get started.
What Are Liquidated Damages?
Liquidated damages are pre-agreed fixed damages payable by one party to another as a means of compensation following a breach of the contract (e.g late performance).
Why Bother with Liquidated Damages?
While liquidated damages might be a thorn in the side of contractors, principals have excellent reasons for wanting to include them in contracts. That said, the clauses do offer contractors a degree of benefit and certainty as well.
Generally the upsides to liquidated damages clauses are these:
- LDs facilitate a simpler recovery of losses arising from late completion. Calculating actual damages is a costly and time-consuming exercise that isn’t necessarily reasonable to undertake on every occasion.
- There is no need to prove actual loss. While the liquidated damages must be a genuine pre-estimate of loss, there is no need when claiming them to tie the liquidated damages back to any actual loss, provided the clause survives scrutiny.
- The contractor gets greater certainty on the risks of late completion so that they can assess the risks and benefits of the project both at commencement and throughout project delivery.
- The losses are governed by a contractual clause which is usually fairly simple, not the much more complex area of calculating losses using the common law (case-based) system.
- Without a liquidated damages clause, disputes arising out of delays would be far more costly and complex. The principal would need to demonstrate breach, loss, causation and mitigation amongst other things.
An Example Liquidated Damages Clause
This clause is taken from AS 4300-1995, with our emphasis added:
35.6 Liquidated Damages for Delay in Reaching Practical Completion
If the Contractor fails to reach Practical Completion by the Date for Practical Completion, the Contractor shall be indebted to the Principal for liquidated damages at the rate stated in Annexure Part A for every day after the Date for Practical Completion to and including the Date of Practical Completion ….AS 4300-1995
How Liquidated Damages Work – Five Essential Elements
There are five major elements which influence when liquidated damages are payable, and how to calculate them:
- Practical Completion;
- The Date For Practical Completion;
- The Date Of Practical Completion;
- The applicable Rate; and
- When the debt actually kicks in.
Let’s deal with each in turn.
Practical completion is the contractual term usually assigned to the status of the project being “basically done”.
Ordinarily it consists of each major stage being finalised, with only minor defects or issues to rectify. Here is a common definition from AS 4300-1995:
‘Practical Completion’ is that stage in the execution of the work under the Contract when—
(a) the Works are complete except for minor omissions and minor defects—(i) which do not prevent the Works from being reasonably capable of being used for their stated purpose; (ii) which the Superintendent determines the contractor has reasonable grounds for not promptly rectifying; and (iii) rectification of which will not prejudice the convenient use of the Works;
(b) those tests which are required by the Contract to be carried out and passed before the Works reach Practical Completion, have been carried out and passed; and
(c) documents and other information required under the Contract which, in the opinion of the Superintendent, are essential for the use, operation and maintenance of the Works, have been supplied.
For liquidated damages, however, practical completion is a critical term. As a contractor in the negotiation phase of your contract, don’t ignore this important definition and how it’s going to apply down the track. It’s essential to assess:
- Are the requirements of practical completion clear?
- Is practical completion capable of objective assessment?
- Can it be properly applied by the party that might seek to levy liquidated damages?
Often, large liquidated damages claims by principals are a direct result of the contractor failing to deal with ambiguity or lack of objective clarity about when practical completion has been reached and how it is to be properly certified.
The Date For Practical Completion
The date for practical completion (not to be confused with the next heading) is the contractual date by which the contractor has promised that practical completion will occur.
Sometimes it might be a fixed date, or a fixed number of days from the contract date. Other times it might be triggered by different timetables or events. Here’s an example clause from AS 4300-1995:
‘Date for Practical Completion’ means—
(a) where Annexure Part A provides a date for Practical Completion, the date; or
(b) where Annexure Part A provides a period of time for Practical Completion, the last day of the period,
but if any extension of time for Practical Completion is granted by the Superintendent or allowed in any arbitration or litigation, it means the date resulting therefrom;
During negotiation and contract administration, the questions most contractors need to ask are:
- Is the date for practical completion clear?
- If not, is the process by which the date for practical completion is to be calculated referable to obvious and unambiguous events?
- Is it open to abuse or subjective elements by the principal, which might impact their ability to claim liquidated damages?
The Date Of Practical Completion
Simply put, the date of practical completion is the date you actually reach practical completion.
However, you need to be clear as a contractor on which triggers the date of practical completion. You might find that you need to give a notice, that a superintendent needs to issue a certificate, or that some other mechanisms need to take place before you can be sure you’ve actually “gotten there”.
So make sure you know the process and allow enough time (if possible) in case something goes wrong.
The Applicable Rate
Normally the rate of liquidated damages is specified in the contract as a fixed sum per day (eg: $5,000 per day). Usually you’ll find the figure in the contract particulars or annexures.
So, for each day between the date for practical completion and the date of practical completion, the principal will be entitled to levy a fixed sum multiplied by that number of days.
With the vast range of contracts, values and potential damages at play, liquidated damages rates can vary widely.
Can Liquidated Damages be an Unenforceable Penalty?
If you’ve done contract law 101 at any point you’ll know that sometimes liquidated damages might be considered a “penalty”. If they are, then they become unenforceable.
But as you’d expect, this is a well-travelled area of law when it comes to construction contracts, and you can’t assume that your liquidated damages clause won’t survive scrutiny.
Most importantly, liquidated damages won’t be a penalty simply because they are high. Remember our definition – the damages have to be a genuine pre-estimate of the losses likely to be suffered.
They don’t need to be accurate or even correct – they just need to be genuine.
So while it’s possible in some limited circumstances to have the liquidated damages clause declared unenforceable, we wouldn’t bet the house on it.
How do the Liquidated Damages become payable?
An often overlooked point concerns when the liquidated damages actually become payable and when they can be set-off against the Contractor’s payment claims.
See from the AS 4300-1995 example above that the Contractor becomes “indebted” to the Principal for the liquidated damages as soon as the Contractor is late. This is an automatic mechansism. This can be contrasted with the drafting in the later Australian Standards (e.g. AS 4000-1997 and AS 4902-2000) where the debt does not become payable until the Superintdent actually “certifies” the liquidated damages.
This might seem trivial but the timing differences can becomes very important in the event of disputed claims, including adjudication under security of payment legislation. For example, it could become a problem for the Principal if, at the relevant “reference date”, the Contractor is late but the Superintendent has failed to actually certify any of the liquidated damages.
How can Contractors Realistically Negotiate on Liquidated Damages?
It might seem that everything is a foregone conclusion when it comes to liquidated damages, but there is often scope for contractors to negotiate the contract terms around liquidated damages, at least to a degree.
A good place to start is by attempting to place an overall cap on the total quantum of liquidated damages that the principal can receive in a given project. So, for example, 5% of the overall contract price is a good place to be when it comes to capping your exposure to liquidated damages. This offers a much greater ability to manage your project risk and protects you from catastrophic losses.
The other common place to negotiate is on the scope of potential damages. Often contracts will allow a principal to claim both liquidated damages and other forms of damage (in particular if their damages exceed the LD rates). Contractors can try to negotiate the terms so that the liquidated damages represent the only remedy for failing to achieve practical completion by the date for practical completion.
The Intersection Between Extensions of Time and Liquidated Damages
While we don’t want to get lost in the wild and wonderful world of EOT claims in this article, it’s important to recognise the clear relationship between extensions of time and liquidated damages.
A validly claimed and granted extension of time will push back the date for practical completion. The result is that the (potential) gap between the date for practical completion and the date of practical completion narrows, reducing the days on which the LD rate applies.
For that reason it’s critical that as part of your contract administration you ensure compliance with time limits on EOT claims, notices and delays. While it’s tempting to let things slide in the interests of your ongoing commercial relationship, there’s a good chance that decisions like that will come back to bite you at the end of the contract.
So if your contract needs you to notify within a particular time, and then every seven days thereafter – do that. If your principal doesn’t like the extra paperwork, then they can agree to amend the contract.
Liquidated Damages in a Nutshell
LDs can make or break a project, so it’s critical to manage the risk well.
In this guide we’ve shown you how to:
- Understand why liquidated damages exist;
- Appreciate the fundamental elements of liquidated damages;
- Negotiate some protections for your liquidated damages exposure; and
- Navigate the interaction between extensions of time and liquidated damages.
Need help with your specific circumstances? Give us call and we’ll help you out.