Back to basics: liquidated damages in construction contracts

What are liquidated damages?

Liquidated damages are a pre-agreed fixed sum that one party to a contract agrees to pay the other in the event that a specific breach of contract occurs.

This differs from the normal remedy for a breach of contract of general damages (or ‘unliquidated’ damages) which involves an assessment (through the courts) of the innocent party’s losses in order to put them back into the position they would have been in had the breach not occurred.

Agreeing liquidated damages for a specific breach beforehand typically removes the need for the innocent party to prove its losses sustained and avoids the need for costly litigation.  It can also give certainty to the party taking on the risk as to what level of liability there may potentially be.

How are they used in construction contracts?

In construction contracts, they can be used in a number of circumstances, including:

• Late completion – specifying an amount of damages (at a certain rate per day or week of delay) that the parties agree will be payable from a contractor to the employer if practical or sectional completion is not achieved by target dates set out in the contract.
• Target internal areas – specifying an amount of damages (at a certain rate per square metre or foot) payable to the employer that the final measured area falls below a specified target gross or net internal area.
• Performance – found in some specialist contracts where contractors need to demonstrate that plant is operational by undertaking various tests. After the tests, the contractor may be liable to pay an amount of damages representing the employer’s expected loss of revenue until certain performance levels are met.

How are liquidated damages calculated?

The traditional test has been that the liquidated damages need to be a genuine pre-estimate of losses that would be sustained through the specified breach of contract.  Unless the rate agreed is deemed as ‘extravagent, exorbitant or unconscionable’ in comparison to the losses actually sustained, thereby constituting a ‘penalty’, the courts would generally enforce this calculation.

However, more recently, the UK Supreme Court has held that the fact that a clause is not a genuine pre-estimate of loss does not necessarily mean that the clause will be a penalty, indicating more willingness by the courts to simply give effect to agreed contractual terms.  Now, a liquidated damages clause may be saved from being seen as penal if it is protecting a legitimate commercial interest and is not seen to be “out of all proportion” to the interest it is protecting and the innocent party’s likely loss.

On that basis, the parties should still look to use a logical basis for agreeing the level of liquidated damages and should keep a record of how the figure was calculated.  The figure should attempt to factor in all losses that may be sustained as a result of the breach of contract occurring, for example, loss of rent / income, prolongation costs for delays, loss of profit, etc.   However, in practice, the figures are often then commercially negotiated to a level acceptable to both sides.

Another important consideration is that the agreement on the rate of liquidated damages will act to limit the innocent party’s claim to that amount, even if the amount actually suffered is more than the rate agreed.  If the parties are therefore struggling to agree an adequate level of liquidated damages, it may be worth leaving the clause with a general damages remedy instead.

When can a liquidated damages clause be challenged?

There are a few circumstances in which a liquidated damages clause could potentially be challenged, including:

• Where the clause is considered a penalty (see above).
• Where the clause is void for uncertainty – as any ambiguity in the drafting (for example, an unclear mechanism for triggering or calculating the liquidated damages) will be construed against the interests of the party relying on the clause.
• Where an act of prevention by the innocent party has caused the breach of contract – an important consideration for delay clauses in particular, for example, if a contract does not allow for an extension of time mechanism for delays caused by the employer, the liquidated damages clause may be rendered invalid and time for completion may be set ‘at large’ with no binding contractual completion date.
• Where contractual procedure has not been complied with – many liquidated damages clauses contain procedure or conditions precedent which must be followed before entitlement to claim the damages crystallises. For example, under a JCT contract, there are normally a number of notices to serve before delay damages can be withheld from the contractor.
• By waiver or estoppel – if, by words or conduct (express or implied), the innocent party represents that it does not intend to deduct the liquidated damages, it may be prevented from doing so if the other party acts to its detriment as a result of the representation.

Are there any other potential pitfalls to be aware of?

More specifically in the context of the commonly found delay damages provisions in standard building contract forms:

• Completing ‘Nil’ as the rate of liquidated damages – a recent case involved parties who seemingly intended not to agree liquidated damages for delay but instead to leave general damages to apply by putting ‘£Nil’ as the rate applicable under the contract. This had the unfortunate effect of the court holding that liquidated damages applied but at the rate of £0 so that there was no right of damages at all for late completion whether liquidated or unliquidated.
• Agreeing to a cap on liquidated damages – it is becoming increasingly common for contractors to ask for a limit to be placed on the total amount of delay damages they may be potentially liable for. An employer should be aware that if this limit is reached, and the delays still continue, there is no further remedy available to incentivise the contractor to complete the works swiftly.
• The effect of terminating a contract on delay damages – a recent case has concluded that terminating a building contract ended the employer’s ongoing entitlement to claim liquidated damages. If a project is therefore in delay and an employer is weighing up all his options, it should think very carefully before issuing a termination notice.

Summary

There are many advantages to incorporating liquidated damages clauses within construction documents and their use is common, particularly as the traditional remedy within building contracts for breach of contract for delays.

However, parties using them need to be wary of the potential traps in their incorporation, including the dangers of agreeing inadequate levels of compensation, their ability to be challenged and potential unintended consequences of poor drafting.

How we can help

If you would like any further advice on any issues raised in this article, or any other construction matter, please contact a member of our construction team.