Liquidated Damages Clauses: Effective and Enforceable?

Geraldine O'Reilly and Isabelle Kelland
19 Jul 2018

A local government is tasked to procure a contract for the construction of a public road.  How can the terms of the contract be used to support its governance objective to ensure the project is delivered ‘on time’?

One way to do this is by paying attention to the liquidated damages clause, which is the legal tool for achieving timely delivery of services.

What is a liquidated damages clause?

A liquidated damages clause is a pre-agreed amount that sets out a sum payable by one party to the other in the event of a delay in the project. The amount is fixed in advance and written into the contract.

Why is it important?

The benefits of an effective liquidated damages clause include the following:

  1. It provides contractual certainty by providing a fixed remedy;
  2. It can incentivise completion of a project on time; and
  3. It can avoid costly and time consuming disputes between parties in the event of delay, since the remedy is already agreed.

However, there are potential traps

To be enforceable, the liquidated damages sum must be a genuine pre-estimate of loss. If a court considers that the amount is out of all proportion it may consider it to be a penalty. Penalty clauses are void and unenforceable, so all the benefits of a liquidated damages clause will be lost.

There is also real risk in agreeing a liquidated damages clause of nominal or “nil” damages, since a liquidated damages clause can cap liability. Such a clause may therefore have the unintended effect of absolving the contractor from any other damages for delay of the project.

Are local governments missing an opportunity?

The problem is that many liquidated damages clauses are drafted with commercial principals in mind. It is easier to calculate losses if the delay in the provision of services is affecting an income-generating business.

It is different for local governments, where most of the projects affect non-profit making infrastructure, such as the public library or community centre. Therefore, local governments often find it hard to quantify the loss that the organisation will face, if the project is delayed.

In thinking that they cannot set a higher and more meaningful rate for the liquidated damages clause, they may settle for a liquidated damages rate of $50 or $100 a day, which is not an effective incentive to the contractor to deliver on time. Often, this is the result of reliance on such clauses in previous contracts, some of which are created by “cut and paste” work by a non-lawyer.

As a result, many local governments find themselves at the mercy of the contractor when it comes to achieving contract deadlines.

Can non-financial loss be included?

Yes, according to the Supreme Court of Tasmania. In State of Tasmania v Leighton Contractors Pty Ltd[1] a liquidated damages clause relating to the late delivery of a public road was challenged by the contractor. The contract specified a rate of $8,000 per day.

The court held “Some component of loss for public utility or delay in access to infrastructure” ought to be considered when setting the liquidated damages amount.

This case also highlighted the importance of preparing a detailed assessment of the likely cost of delay in completing a project and using that as a basis for the liquidated damages calculation.

The case supports the enforcement of the amount, even where the project is funded by another government agency.In some instances, an appropriate measure of liquidated damages may be the cost of capital tied up for the period of delay.

What does this mean for local governments?

This case suggests that local governments can be more optimistic of the effectiveness of liquidated damages clauses in their contracts, providing they are based on a full and accurate calculation of a pre-estimate of loss and are correctly drafted.

Conclusion

It is not a good idea to rely solely on past practice. Nor is it good practice to cut and paste from a standard contract, because you may well be missing out on the opportunity to support your governance goals in ways you are not even aware of. Moreover, you may also be exposing your local government to risk.

This is one area where it pays to get the proper legal foundations laid at the start of your construction projects, rather than have to deal with the financial and reputational fallout if they run over time.

 

[1] State of Tasmania v Leighton Contractors Pty Ltd (2005) 15 TASSC 133.

 

Contact: Geraldine O’Reilly

Download Original PDF

 

Disclaimer: This article provides a general summary of subject matter and does not constitute legal advice. The law may change and circumstances may differ. Therefore, you should seek legal advice for your specific circumstances.