Back to Basics: Liquidated Damages

A liquidated damages clause is a powerful tool within a written construction contract. It can be thought of as a contractual Swiss army knife: it does a little bit of everything, and it can help the wielder out in a jam. It incentivises contractors to comply with their contractual obligations with respect to the project in question. It provides comfort to employers by mitigating against the financial uncertainties associated with risks such as delay. It can also focus minds in the midst of disputes. However, like any tool, the wielder of a liquidated damages clause can hurt themselves if they don’t know how to use it in a responsible fashion. This article will provide a brief overview on what liquidated damages clauses are and how they can be used.

What are liquidated damages?

Where a party to a contract fails to honour its obligations under and in terms of that contract, then that party (the ‘defaulting’ party) is said to be in breach of the contract. In those circumstances, the other party to the contract (the ‘innocent’ party) is entitled to claim compensation from the defaulting party for any losses that it has incurred as a result of the defaulting party’s breach. The legal term for this compensation is ‘damages’.

A common example of a breach of contract in a construction context is where a contractor fails to complete the works by the agreed date for completion. However, it isn’t always easy to calculate the loss that might be suffered by the employer in this scenario. For example, the employer may lose out on receiving several months’ worth of rent. The dilemma is that the amount of damages can often be difficult to determine. The parties may, and often do, disagree as to what a reasonable amount looks like. Typically, if agreement cannot be reached, it is necessary to bring an action before the courts and let the courts decide how much compensation is due. That is an expensive and time-consuming process. Indeed, the cost of arguing the case in court can – and sometimes does – eclipse the value of the loss suffered in the first place.

This is where liquidated damages come in. The parties to a construction contract can agree, in advance, on an amount of compensation that will be due in the event of a breach of contract due to delayed completion of the works. This pre-determined amount is “liquidated” in the sense that it is a known quantity. If the breach is established, then the agreed amount of liquidated damages must be paid or deducted from any sums due to the contractor (provided, of course, that the liquidated damages clause is valid and enforceable – more on that to follow).

How to use a liquidated damages clause

In the first instance, it is important to ensure that the liquidated damages clause is properly drafted and therefore legally valid and enforceable.

The leading case in Scots law on liquidated damages clauses is called Dunlop Pneumatic Tyre Company Ltd     -v- New Garage and Motor Company – a decision which dates from 1915. Despite this case being more than 110 years old, it remains good law today. The principles established in this case were more recently affirmed by the UK Supreme Court in two conjoined cases which were decided in 2015.

The courts have held that the validity and enforceability of a liquidated damages clause will depend on whether the clause is reasonable or punitive in character. The clause will be reasonable if the amount of liquidated damages is a reasonably legitimate estimate of the losses that Party A may suffer as a direct and foreseeable consequence of the breach of contract by Party B. The clause will be punitive if the amount of liquidated damages is, for example, arbitrary, excessive, or extravagant. Essentially, that means that the amount cannot be a random, large number, which bears little or no relationship to the loss actually suffered, purely to punish the defaulting party for breaching their obligation. For example, a liquidated damages clause which provided that no matter the seriousness of the breach of contract by Party B, Party A would be entitled to receive £10,000 from Party B in liquidated damages, would be punitive (i.e. it would be viewed as a penalty) and unenforceable in law. On the other hand, if a quantity surveyor or accountant has produced a reasoned opinion for Party A which opines that a delay to completion would result in Party A losing £5,000 per day in profit, then a liquidated damages clause compelling Party B to pay £5,000 to Party A for every day that the works go beyond the date for completion (in circumstances where Party B is liable for that delay) would be a reasonable clause as it would reflect a reasonably legitimate estimate of Party A’s losses.

Whether the clause is reasonable or punitive in character is a question that the courts will resolve by having regard to all the facts and circumstances of the case as known to the parties at the time of entering into the construction contract.

Assuming that the liquidated damages clause is valid and enforceable, the next issue to consider is the question of when the trigger can validly be pulled on the clause. This can often be very difficult to determine as it depends on whether the contractor has actually caused the delay in completion or whether that delay has, in fact, been caused by the employer.

Many Standard Form Building Contracts, such as the SBC/Q/Scot (2016 Edition), provide that certain causes of delay to the completion of the works will entitle the contractor to ask for more time to complete the works. These causes of delay are known as “relevant events”. If the works are delayed by something which is not a relevant event, then the contractor will not be entitled to seek an extension of time to complete the works and, in that case, the employer may be entitled to insist on payment of liquidated damages, subject to compliance with the notice provisions under the contract.

The consequences of having a liquidated damages clause

It should be noted that a liquidated damages clause will not automatically be implied into a construction contract. Such a clause must be negotiated and agreed on. To say that it would be advisable to record such a clause in writing is an understatement. All construction contracts, regardless of the nature of the project, should be recorded in writing. While this is not a legal necessity, it goes without saying that it is highly recommended.

Liquidated damages clauses provide parties to construction contracts with a degree of certainty. However, that can be something of a doubled edged sword. The amount of damages is pre-defined. That means that even if the actual loss is less than the amount specified, the amount specified must nonetheless be paid.

There is no requirement to prove that a loss has been incurred in an amount which is on par with the sum specified in the liquidated damages clause. There is equally no requirement to take any steps to mitigate against the loss suffered. Such steps are often taken in cases where no liquidated damages clause exists, to demonstrate that the sum sued for by way of compensation is a reasonable sum. However, on the flip side, it is not possible to insist on payment of an additional sum over and above the liquidated damages in circumstances where the loss suffered is greater than the sum specified in the clause.

A liquidated damages clause therefore caps liability at a pre-determined amount. Think of it as certainty but with a ceiling. It is therefore important to consider carefully whether to agree on a liquidated damages clause in the first place and, if such a clause is agreed, to give equally careful consideration to the amount to be specified to be paid.

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Our expert construction disputes team is regularly engaged to assist with delay disputes on ongoing and completed projects. If you have any queries with which we could assist, contact Liam McKay or a member of our Construction Disputes team.