A properly drafted liquidated damages (LDs) clause is an essential element of any construction contract, in which the parties seek protection from delays. LDs provide certainty to both parties, incentivize performance and facilitate the recovery of damages without the difficulty and expense of proof.
To avoid the pitfalls of improperly drafted or ineffective LDs clauses, we have summarised ten key points to keep in mind when drafting a delay-related LDs clause.
Ensure the LDs calculation agreed upon by the parties is a genuine and reasonable pre-estimate of the losses likely to be suffered upon a breach
The courts will not enforce an LDs provision that operates to impose a penalty on the party in breach. Accordingly, the LDs clause should set out a method of calculating the LDs which reflects a genuine and reasonable pre-estimate of the loss that the principal would be likely to suffer as a result of delay. With this in mind, we suggest the following:
- draft the LDs clause to include a formula for calculating loss when a breach occurs;
- draft the LDs clause to include a calculation fixed by a scale, ie. a sum to be paid on a daily, weekly or monthly basis for the period of the delay; or
- where an estimation of the LDs as a lump sum is relatively simple, draft the LDs clause to include that estimated sum.
Use lump sums with caution, as a lump sum without more support tends to suggest arbitrariness rather than a genuine pre-estimate of damage. With this mind, parties should avoid drafting LDs provisions such that:
- the damages are couched in terms of a minimum lump sum or an agreed rate, even though the proprietor has the right to take possession of completed parts of the work or the LDs can also cover events which are more trivial (eg. a minor defect or the non-provision of as-builts);
- the principal is entitled to suspend or withhold payment to the contractor of other money due without reference to a rate of LDs that can properly be deducted; or
- the principal is entitled to forfeit all retention money.
Keep a record of the basis of any calculation or rate and any supporting material
Irrespective of the basis for calculating the LDs, evidence of the calculations or basis for a rate (especially if it is a lump sum) must be retained. These records will provide a means for defending challenges concerning arbitrariness of the calculation contained in a particular LDs clause and will establish that the LDs were a genuine pre-estimate of the loss which might be suffered.
Incorporate recognition of the parties’ relative bargaining power
Recent case law has given consideration to the parties’ relative bargaining power when determining whether an LDs clause is valid.
While acknowledgement within the contract of equal bargaining position may not be conclusive, it will be helpful. Similarly, acknowledgement by the parties that the sum is not considered to be penal will be helpful.
Ensure that the LDs clause is not void for uncertainty
To avoid uncertainty, detail the following:
- the amount and relevant calculation of the LDs payable or the formula to be applied;
- the time period in which the LDs accrue (eg. carefully define terms such as Practical Completion and make sure a date for Practical Completion is specified);
- when the LDs are entitled to be deducted, or set off, from payments; and
- the party who is entitled to payment and the party who is obligated to pay, eg. the amount of LDs payable is due from the contractor to the principal.
The more certainty an LDs clause provides, the more effective the clause will be and the less likely it will be found penal.
Avoid cumulative calculations of LDs in staged completion contracts
Care must be taken with staged completion contracts to ensure that any LDs applicable to a stage are a genuine pre-estimate of the loss caused by the delay of that stage (eg. such as the additional costs to a subsequent phase which might be caused by the delay) rather than the loss caused by the eventual delay to completion of the contract as a whole. A cumulative calculation of damages should be used very carefully as they may be considered penal.
Set out contractor’s entitlement to claim extensions of time
If the contract does not provide an effective extension of time ("EOT") regime, under the prevention principle the principal may lose its right to levy LDs if an act or omission by the principal prevents the contractor from achieving completion. Unless the principal is able to grant an EOT in such circumstances time will be rendered "at large", the contractor will only have an obligation to complete within a reasonable time and will only be liable to pay general damages.
Accordingly, the EOT regime should be as comprehensive as possible and provide for:
- the contractor's entitlement to claim EOTs for acts of prevention by the principal;
- comprehensively set out which acts of prevention the principal is responsible for;
- the principal/contract administrator's unilateral right for the benefit of the principle to extend time regardless of whether an EOT has been requested by a contractor;
- the contract administrator's authority to apportion between such principal responsible delays and other delays; and
- specify a time period by which the superintendent must grant an EOT.
Avoid waiver issues
The right to LDs can be extinguished by an express or implied waiver.
This is more likely, when payments are made under the contract without a deduction of LDs, notwithstanding express provisions enabling these deductions. To prevent an unintended waiver:
- include a general and specific (to LDs) exclusion of waiver clause;
- take extra care with payments or certification where:
- the contract expressly provides that the LDs are to be deducted from sums due to the contractor; or
- the contract administrator has power to extend time or to account for any LDs due to the principal when certifying the final balance.
Enable pass through to subcontractor
If drafting on behalf of a main contractor ensure that any LDs levied by the principal can be passed through to any subcontractor by allocating to each subcontractor the appropriate portion of damages they would cause, or by obtaining an indemnity.
Ensure that adequate security is in place
A principal should ensure that its LDs clause operates effectively by:
- Ensuring that the contract contains a set-off provision in favour of subtracting any entitlement to LDs from any payment due to the contractor. PC-1 and the Australian Standard Contract differ in certification procedure and therefore require scrutiny of the principal's right to set-off; or
- Ensuring that adequate security is in place to cover the maximum LDs payable and that it is capable of being called, upon the occurrence of delay, without proof of such a delay. It is worth noting that the contractor may include the additional cost associated with providing that security in its tendered price.
Take care using the word "nil" in completing standard form contracts
The Australian Standard conditions (and many other international standard form contracts) provide a space for LDs in Annexure A. If the parties do not intend that the LDs provision be applicable and wish that general damages will be payable instead, the preferred course would be to:
- delete the relevant clause and initial the deletion; or
- insert the words "Not used" in the space provided in the Annexure.
Writing "Nil" or "Not applicable" in the designated space may be interpreted to mean that no damages, liquidated or unliquidated, are to be paid for delay.
 Liquidated damages clauses can be drafted for breaches other than delay eg. failures to meet certain performance criteria, but this article deals with delay-related liquidated damages clauses only
 In international contracts it is possible that the LDs provisions will in fact be referred to as the penalty provisions (particularly in the US). This will not be fatal if the LDs do not in fact constitute a penalty. However, we would suggest such references be avoided where Australian parties are involved.