Reviewing your contract is one of the most important aspects of any business relationship. If you work in industries such as construction, you may have come across a liquidated damages clause.
Like any other contract, you want to make sure your agreement covers any possibility of non-performance. In other words, what might happen if the job isn’t done as agreed?
This is where a liquidated damages clause might come in handy.
What Is A Liquidated Damages Clause?
Before we go into the clause itself, it’s important to understand liquidation.
Generally speaking, liquidation is when a business winds up and distributes its assets to creditors. In other words, when a business stops operating, this is their way of ‘paying people back’ when they are owed. Under liquidation, this may require converting assets into cash.
So, a liquidated damages clause covers the amount of damages to be paid if a contract is breached. The key feature here is that a liquidated damages clause is set out in case of a breach, so it’s usually in the contract before parties even agree to it. Therefore, it’s predetermined.
Liquidated Damages vs Unliquidated Damages
Liquidated damages are quite different from other types of damages. Let’s think of unliquidated damages (also known as general damages).
Liquidated damages are predetermined, so it’s already fixed from the outset (so, before the breach). General damages, on the other hand, will be calculated depending on the court’s decision following the breach.
When Would You Need A Liquidated Damages Clause?
While some industries would prefer to deal with breaches after they occur, some business arrangements would be easier with predetermined damages. One of the most common industries is construction.
This is because there is a possibility that the work or project will not be completed in time. If this is the case, the contractor (person completing the work) will need to pay the fixed amount to the principal (the other party). So, this limits any potential disputes around payment as the contract already sets out the exact amount the contractor needs to pay if work is incomplete.
Cap Constructions has hired a contractor, Billie, to do some construction work for them. This is a very important project where Cap Constructions has poured a lot of money into insurance and future projects.
In their contract, it says that Billie needs to complete the work within 2 months.
If the work still isn’t done after the 2 month period, Billie needs to pay a total of $2,500 for each week it remains incomplete. The clause that stipulates this is the liquidated damages clause.
So, if Billie finishes the work 2 weeks later than the contract requests, she will need to pay $5,000 in damages.
What Does It Include?
A liquidated damages clause should be drafted depending on the unique business relationship. Generally speaking, however, the following details should be included:
- Practical completion – the clause should define or include a test to determine whether the defects of the incomplete work is to the extent that it cannot be used for its intended purpose
- Date for practical completion
- Test for breach – at what point is it considered a breach of contract requiring damages? For example, if the finished product can still fulfil its intended purpose, could that be sufficient grounds to disregard any defects or unfinished work?
How Are Damages Calculated?
The amount of damages you agree upon will depend on the needs of the principal and the contractor. If you are the principal, it’s worth considering the various costs involved in the project when deciding the right amount of compensation.
For example, consider:
- Insurance – how much are you paying for insurance policies?
- Administration costs
- Staffing costs – how much are you spending on additional resources for this project?
- Any money lost as a result of the delay
Despite all of this, each agreement and business relationship is unique. Accordingly, terms such as liquidated damages will depend on that specific relationship and the likely losses that may come from a breach. This is why it’s a good idea to have a lawyer draft one for you (it’ll also reduce the likelihood of the clause amounting to a penalty, which we’ll cover shortly).
Pros And Cons Of Liquidated Damages
A liquidated damages clause is a great incentive for the contractor to finish the work in time (or even better, earlier than expected!).
It also gives them a heads up as to how much they’d need to pay in case the work is incomplete. This way, they’d know whether they want to commit to their responsibilities before they enter into the contract.
However, the main benefit of this type of clause is that the principal can avoid further issues down the track. Setting out damages at the beginning of the business relationship will help avoid any delays that could then start a domino effect for the project. It also reduces the need to turn to ADR (Alternative Dispute Resolution) in case things go wrong. This saves a lot of unnecessary stress, and could potentially preserve a healthy business relationship.
Nonetheless, the damages agreed upon might not always be reasonable. Let’s say the contractor does not complete work, but the amount of work omitted is not so much as to justify a large amount of damages to be paid. In other words, the predetermined amount of damages is not proportionate to the amount of incomplete work or non-performance. This is where penalties come in.
How Do You Enforce A Liquidated Damages Clause?
If you choose to enforce a liquidated damages clause, the court will need to determine a few things. One of the first things they will consider is whether the damages were genuinely estimated. Put simply, did the parties think about the likely extent of loss that would be suffered when estimating the amount of damages to be paid?
If it is not considered genuine, this can amount to a penalty on the breaching party.
What Are Penalties?
A penalty is a clause that instructs one party to pay a sum (so in this case, liquidated damages) that is not proportionate to the breach or loss suffered. For example, a clause may require the contractor to pay an excessive amount of money for a small loss or omission. Since this isn’t considered fair, a penalty will not be enforced by the court.
So, how do you decide if a clause amounts to a penalty?
The case of Paciocco v Australia and New Zealand Banking Group Limited  outlined some basic principles to follow when deciding whether a clause amounts to a penalty.
This matter is a question of construction. This means that the court needs to consider the individual circumstances of the parties at the time the contract was made, rather than when the breach actually occurred. Overall, there are a few key factors to think about when deciding whether the clause is a penalty:
- Is the sum ‘extravagant and unconscionable’?
- Is it ‘out of all proportion’ in light of the greatest possible loss from a breach?
- Is the sum payable for different levels of seriousness (a serious breach vs a trivial breach)
- What is the effect of the clause?
Depending on your industry, having a thorough and well-drafted liquidated damages clause is an important feature of your business arrangement. It motivates the contractor to complete the work as agreed, and helps everything else run smoothly.
If you need help drafting a liquidated damages clause, or have questions about your contract, Sprintlaw has a team of lawyers who can help. You can reach out to us at email@example.com or contact us on 1800 730 617 for an obligation-free chat.
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