Liquidated damages are predetermined amounts specified in a contract, payable if certain conditions, like project delays, are unmet. These agreed amounts provide straightforward remedies for breaches, ensuring accountability and avoiding prolonged disputes over indeterminate losses.
If the contractor is unable to achieve completion within the contractually agreed time for completion (or if the contract does not state a time for completion, within reasonable time), then the principal is entitled to claim damages from the contractor.
Damages could be expressly stated in the contract as a fixed sum payable at set intervals, typically per day or per week of delay. This is known as liquidated damages and represents a predetermined quantum of damages payable based on the estimated loss that a principal will suffer as a consequence of the contractor’s delay.
The purpose of setting the liquidated damages in a contract is to avoid the need for the principal to prove its actual loss as a result of failure by the contractor to complete the contract by the date for completion. For the contractor, liquidated damages may also be beneficial as it limits and makes known the contractor’s liability for late completion.
Before entering the contract, contractors should carefully consider the rate specified for liquidated damages. Liquidated damages should be based on a genuine pre-estimate of damages likely to be suffered as a result of delay by the contractor. To mitigate the effects of liquidated damages, contractors could negotiate a lower rate for liquidated damages or insist that liquidated damages be capped at a certain amount.
Liquidated damages must not operate as a penalty as penalties are not enforceable; this is based on the rule against penalties which states that a secondary obligation in the event of a breach of contract will be considered a penalty unless the clause amounts to a genuine pre-estimate of damages.
In simple terms, the Courts distinguish between a contractual term that provides for a genuine pre-estimate of damages in the event of a breach (which is enforceable), and a penalty for breach of contract (which is not enforceable). The rationale is that punitive provisions in contracts should be constrained and their remedial function confined to the achievement of performance expectations, of which punishment formed no part.
Given that delays are common in the construction industry, it is also common for contractors to challenge liquidated damages on the basis that it is a penalty. In considering whether a clause amounts to a penalty, the Courts will take into account the following factors:
These requirements are not easily satisfied. In Honeybees Preschool Limited v 127 Hobson Street Limited [2020] NZSC 53, a landlord covenanted with a prospective tenant to install a second lift in the building that was to be leased by the tenant by a certain date. If the lift was not installed by that date, the landlord agreed to indemnify the tenant for all obligations under the lease.
By the time the matter reached trial, the lift was 14 months overdue. The Court held that the indemnity provided by the landlord was not an unlawful penalty as its purpose was not to punish non-performance. Further, the amount claimed, approximately $550,000.00, was not all out of proportion to the tenant’s legitimate performance interest in securing a second lift.
The commercial context of that case was that the second lift was important to the tenant who was seeking to run a childcare centre at the property. It had a licence for only 24 children, but after 14 months the rental liability would be fixed by reference to a fully licensed facility of 50 children. The lack of a second lift precluded the tenant’s eligibility for a full license of 50 children and by extension, the commercial viability of the entire business. This was known to the landlord, and both parties were commercially astute.
In ACM Removals Limited v Southern Demolition and Salvage Limited [2019] NZHC 124, Southern was engaged to demolish a building in Christchurch. It subcontracted with ACM to carry out the removal of asbestos discovered in the walls. ACM submitted an initial quote for the work on terms that provided for a late payment fee including “a daily charge of 0.125% of the contract value”.
The contract value was agreed at $461,000.00. Southern paid 75% of the contract value and refused to pay the rest as the parties disagreed over whether the asbestos removal was complete. Southern cancelled the contract and engaged another contractor to complete the work.
ACM claimed a daily rate of $663.00 in damages. When applied to the period of alleged default, the claim for liquidated damages was $454,000.00, slightly less than the contract value. While the Court held that ACM failed to complete the asbestos removal and therefore not entitled to claim liquidated damages, the Court went on to analyse whether the liquidated damages clause was a penalty.
The Court considered that the parties had similar bargaining power, and the daily rate of $663.00 was relatively minor when compared to the contract value. However, the Court found that the clause was a penalty as there was a “lack of relativity between the late payment fee provided by the contractual term and the potential loss or risk arising from non-payment”.
In essence, the Court considered that the fee would apply equally whether $1.00 or $100,000.00 was owed. This indicated that the formula was penal. Had the clause been drafted in a way such that “its application and effect could, at least in some moderate or broad way, be calibrated to take into account the amount owing on the contract which it is seeking to recover”, then such a clause may have been legitimate.
Courts will interpret each liquidated damages clause on its particular facts. Apart from whether the rate in question is a genuine pre-estimate of damages, the parties should also carefully consider the words used in the liquidated damages clause. For example, inserting “N/A” in a clause to describe the liquidated damages rate may be interpreted to mean that nothing is payable or liquidated damages do not apply and general damages are payable. If the word “nil” is used, this could indicate that the clause was intended to be an exhaustive statement of the principal’s entitlement to damages for late completion, being zero, including general damages.
Where liquidated damages are not provided for in a contract, the principal is still able to seek its actual loss from the contractor provided that it can prove such losses. However, this could be a costly exercise and is likely to be disputed by the contractor. Accordingly, it may pay to utilise the liquidated damages clause to avoid costly disputes.
Contact us if you have experienced delays in your construction project. Our lawyers at Norling Law can review your delayed circumstances and discuss strategies on how to progress your project as part of our no-obligation legal consultation.
Brent is the Director of Norling Law. He has a wealth of experience in the District Court, High Court, Court of Appeal and Supreme Court. Brent is passionate about negotiating favourable outcomes for his clients and able to implement this in his daily negotiations.
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