Back to Basics: How to use liquidated damages clauses effectively

Liquidated damages (LDs, or sometimes referred to as "liquidated and ascertained damages" or LADs) are an agreed or pre-determined level of damages, which can be deducted by an innocent party from a defaulting party in the event of certain contractual breaches. Very often, they are deducted in respect of delay, although they can also be deducted when there has been a failure in performance. They are used as an alternative to the general damages that might be recoverable in the event of a contractual breach – the innocent party cannot recover both in respect of the same losses.

In this article in our Back to Basics series, we discuss the topic of liquidated damages and what the parties to a contract need to consider at drafting stage. The series provides practical insights on key construction topics in relation to English law for non-English qualified in-house lawyers, contract managers and construction professionals.

General vs liquidated damages

If there is a contractual breach which causes a party to suffer losses, that party can recover general monetary damages from the defaulting party.

The innocent party will need to prove both the breach and its losses in order to recover general damages. The level of damages, i.e. the monetary sum to be awarded to put the innocent party back into the position they would have been in had there been no breach, must then be determined, whether by the parties (if there is no dispute) or more likely by a court or arbitral tribunal.

These general damages can be referred to as "unliquidated damages", meaning that the parties did not agree in advance the level of damages to be recovered.

The complexity of engineering and construction contracts means that it is often very difficult to assess actual or general damages, particularly for delay. Agreeing a level of liquidated damages can resolve this difficulty and a well-drafted liquidated damages clause can provide both parties with increased certainty.

As well as agreeing the monetary value associated with a breach, such a clause can enable parties to link the value to a breach – for example, a certain sum can be agreed to be due and payable by a contractor to the employer for each day of delay.

It is very common for parties to agree liquidated damages for delay, as in the example above. The delay could be a failure to complete part of the project in line with the schedule, or the whole of the works by a contractual completion date. Liquidated damages can, however, be applied more generally. A breach in achieving most measureable deliverables will usually suit the application of liquidated damages. For example, a failure to achieve particular results in testing could be linked to pre-determined damages. Liquidated damages can also be agreed to be paid by the employer to the contractor – for example, in relation to a delay in granting access to the project site.

As well as providing an exhaustive remedy for a particular form of breach, the contract can include a limit or cap on the total sum of liquidated damages to be paid for the delay.

Often the paying (defaulting) party will challenge the validity or application of a liquidated damages clause. It is not impossible, though, to foresee circumstances where the innocent party might challenge the validity of a liquidated damages clause – perhaps if the liquidated damages will not compensate them for the damages actually suffered, making general damages a more attractive remedy. To protect and ensure the certainty that a liquidated damages clause can provide, parties will want to make sure the clause is sufficiently robust to withstand challenges.

Issues to consider when using liquidated damages clauses

• If the liquidated damages clause can be shown to be uncertain, the clause could be void for uncertainty and unenforceable. The interpretation of a liquidated damages clause will be subject to the same interpretation rules as any other clause in the contract and an uncertain clause can be unenforceable, if it is unclear. The more complex the terms of a liquidated damages clause are, the more likely it will be void for uncertainty and unenforceable.
• If the actual breaching event does not fall within the scope of the breach anticipated by the liquidated damages clause, the clause will not take effect. For example, a liquidated damages provision might be engaged by any delay, however it is caused. But it might not be engaged by an event that, in turn, causes delay.
• If liquidated damages are intended to be an exhaustive remedy to capture any delay, the clause should be drafted to make that clear. Be aware, though, that if liquidated damages are expressed to be the sole remedy for delay, and the clause is challenged and found to be unenforceable, then the innocent party will be left with no entitlement to claim general damages for breach.
• Sometimes, liability to pay liquidated damages depends upon the innocent party complying with some form of condition precedent. This might be a requirement to give notice to a defaulting party of the breach and, perhaps, giving that party time to remedy the breach.
• The English courts tend to uphold liquidated damages clauses. However, if the clause appears disproportionate to the interests of the innocent party, it might be considered a penalty and therefore unenforceable under English law. It is up to the contractor (or the defaulting party) to prove the clause is a penalty. There was a presumption that this could be established by showing that the liquidated damages were not a "genuine pre-estimate of loss," but this is only one factor and other factors may be relevant. So, even if the liquidated damages are not a "genuine pre-estimate of loss", they may still be enforceable.^[1]
• If a standard form contract is being used, the parties should be careful when completing the rate of liquidated damages in an appendix or schedule. Where parties have inserted "nil",^[2] the courts have found that the parties had agreed there should be no damages at all – including general damages – for delayed completion. In a similar case where parties had inserted "N/A"^[3] next to "limit of liquidated damages", the courts found that this meant that LDs did not apply at all.
• The inclusion of a liquidated damages clause is not isolated from the rest of the contractual terms. For example, if a contract provides for liquidated damages for delay, there needs to be consideration for circumstances where the contractor is prevented from completing due to something the employer did (or something has happened that otherwise falls under the employer's risk under the contract). This difficulty is remedied by including an extension of time provision, which enables the parties to extend the time for completion. This ensures the contractor does not become liable to pay liquidated damages because of something the employer did, or something beyond the contractor's control.
• A contractor might want to pass liability for liquidated damages under a main contract down to a sub-contractor. This is not always straightforward. The contractor will, amongst other things, usually want to ensure that:
  • It can recover liquidated damages from its subcontractor in the same circumstances that it might be liable for liquidated damages under the main contract.
  • The contractor will not be in a position where it could recover liquidated damages from multiple subcontractors that, in total, are greater than the damages it will pay the employer – so making a financial gain, which could give weight to any argument that a subcontract liquidated damages clause is a penalty.
• If a delayed contract, under which liability for liquidated damages has arisen, is terminated before completion, liquidated damages will not be recoverable after the date of termination. At that point, the remedy for loss becomes general damages.^[4]
• If the contract provides for a limit or cap on the total sum of liquidated damages to be paid in the event of delay, parties may also wish to consider stating whether, and in what circumstances, the same cap will apply to any claim for general damages in the event that the LDs clause is found to be unenforceable.

What to consider when drafting a liquidated damages clause

Parties should:

• Be definitive and prescriptive about the event that will allow a party to recover liquidated damages from the other party.
• Ensure that the agreed rate of liquidated damages is not out of proportion to the innocent party's interests, i.e. the losses that party may suffer in the event of breach. One way of achieving this is to ensure, as much as possible, that the LDs to be deducted are a genuine pre-estimate of the losses likely to be suffered.
• Ensure the clause is clearly drafted to avoid any uncertainty.
• Ensure that the clause fits the contractual matrix, without giving rise to conflicts with other provisions.
• If using a standard form contract, ensure that the standard form has been properly completed to include the rates of liquidated damages or, if liquidated damages do not apply, amended to exclude the provision but to make it clear that general damages, if still intended to apply, will still be available.

Key considerations for liquidated damages clauses in construction contracts

At the outset of a construction or engineering contract, agreeing a clear and certain liquidated damages clause can provide the parties with valuable comfort as to the risks they are taking – both in entering the contract and also as events occur during a project's lifetime. To ensure the liquidated damages clause is enforceable, the parties should properly negotiate the terms and the level of liquidated damages to be applied in the event of a particular breach.

If a breach occurs, the parties should be alive to any condition precedents that must be satisfied, before liability to pay liquidated damages actually arises.

If you have any questions about the points raised in this article, please contact Mike Stewart or Mary Lindsay. For more insight into key construction topics in relation to English law, look out for more updates from our 'Back to Basics' series of articles for non-English qualified in-house lawyers, contract managers and construction professionals.

Please also see our recent article in this series, which explored what to consider when choosing or using international arbitration agreements, for related insight into other relevant topics.

Footnotes:

[1] Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] A.C. 79, Phillips Hong Kong Ltd v The Attorney General of Hong Kong Co (Hong Kong) [1993] UKPC 3a and Cavendish Square Holdings BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67.
[2] Temloc Ltd v Errill Properties Ltd [1987] 39 B.L.R. 30. 
[3] Silent Vector Pty Ltd t/as Sizer Builders v Squarcini [2008] WASC 246, an Australian case which is not binding on English courts but may be cited as guidance.
[4] Triple Point Technology, Inc v PTT Public Company Ltd [2021] UKSC 29.