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.
Liquidated damages
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.
Prohibition against penalties
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 which 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 rational is that punitive provisions in contracts should be constrained and their remedial function confined to 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:
- The type of construction and context at the time the contract was made;
- Whether the secondary obligation is out of all proportion to any legitimate interest in the enforcement of the primary obligation, or is exorbitant or unconscionable, having regard to the interests of the innocent party. The degree of proportionality between the contractually stipulated consequence and the loss likely to be suffered will inform the assessment of disproportionality;
- The commercial context of the clause, including the relative bargaining power of the parties and whether they were commercially astute;
- Whether the predominant purpose of the impugned clause is to punish rather than deter non-performance; and
- Whether the clause protects a legitimate interest.
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 which provided for a late payment fee including “a daily charge of 0.125 percent of the contract value”.
The contract value was agreed at $461,000.00. Southern paid 75 percent 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 works.
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.
Conclusion
Courts will interpret each liquidated damages clause on its own 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 is able to 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 delay circumstances and discuss strategies on how to progress your project as part of our no obligation legal consultation. To book a free 30-minute consultation please click this link https://norlinglaw.co.nz/consultation-brent/.
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.
Anna practices in the area of commercial litigation and has appeared as Counsel in the District Court, High Court and the Court of Appeal, having successes in all Courts. Anna has a special interest in corporate, insolvency and relationship property law.
Wendy has over 20 years’ experience in civil litigation in New Zealand with a main focus on construction, insolvency and debt recovery and security enforcement.