Essential law: Liquidated damages, part one

Liquidated and ascertained damages (LADs) are a common mechanism used in construction contracts to fix a predetermined amount that will be payable by one party to the other in the event of a specified breach.

They are commonly payable by the contractor where the works have not been completed by a specified date or where the performance of the works does not achieve specified criteria. LADs usually operate as an exhaustive remedy thereby excluding any claims for general damages, although this is subject to the wording of the particular contract.

They benefit employers by giving certainty as to the amount payable in the event of a specified breach without having to spend time and effort in proving such losses. They benefit contractors by effectively capping their potential liability for the relevant breach and giving them certainty as to their potential exposure so they can accurately price the risk.

When can LAD clauses be challenged?

The courts’ starting point is that they are generally averse to interfering in the agreed terms of a contract to say that any of its terms are unenforceable, particularly for a contract negotiated between commercial parties. However, there are some ways a party may successfully challenge the application of LADs.

• If the LADs provision is void for uncertainty. While bad drafting of a contract can make an LADs clause difficult to interpret and apply, the courts will generally seek to interpret ambiguous or uncertain clauses within contracts in such a way as to make the clause valid. However, there are examples of such a challenge being successful, such as the Hong Kong case of Arnhold & Co vs The Attorney-General of Hong Kong, where the LADs clause was held to be void for uncertainty as it provided for a minimum and maximum daily LADs figure but failed to provide how the figure should be fixed within that range.
• If the employer has not complied with a condition precedent to its right to claim LADs. This will depend on the particular drafting of the contract.  It is common in the JCT forms to require certain conditions to be met before LADs can be claimed, such as the employer issuing a certificate of non-completion, and notifying the contractor prior to the due date for final payment that LADs are required to be paid by the contractor.  
• There may be an express or implied waiver by the employer of its right to claim LADs. In addition, the employer may be estopped from relying on its right to claim LADs if it has represented that it does not intend to do so and the contractor has acted to its detriment in relying on such a representation.
• Time has become “at large” because the contract’s extension of time provisions do not provide for an adjustment to the completion date where there has been an act of prevention by the employer.  The prevention principle then operates to prevent a party from benefiting from its own breach and enforcing the LADs clause for the completion date required by the contract. Instead, the contractor is only under an obligation to complete the works within a reasonable time and the LADs clause will potentially fall away.
• If the LADs clause constitutes a penalty. A penalty is the exertion of undue pressure on a party to perform a contractual obligation, which the courts will not enforce on grounds of public policy. The test set out in the Supreme Court decision in Cavendish vs Makdessi is whether or not the clause imposes a detriment on the contract-breaker “out of all proportion to any legitimate interest of the innocent party” in the enforcement of the primary obligation.  This is an evolution from the previous test as to whether the rate of LADs was a genuine pre-estimate of loss, as the Supreme Court recognised that an LADs clause may be properly justified by other considerations than the desire to recover compensation for a breach.  However, if the rate of LADs can be shown to be a genuine pre-estimate of loss, this should still be sufficient to show that it is not a penalty.

The penalty argument is generally difficult to succeed with if it follows an arm’s-length commercial negotiation of the type common in construction contracts. However, situations where it may be successful include where:

• The employer takes part of the works into partial possession but the contract does not provide for the LADs to be reduced in proportion to the value of the works taken into possession.
• The contract provides for sectional completion but does not provide a mechanism to calculate the LADs payable for each section that reflects the likely loss that would be suffered in the event that completion of that section was delayed.

Our next instalment in this series will review issues that can arise when LADs clauses are found to be unenforceable.

James Worthington is a partner and Carolyn Davies an associate at Charles Russell Speechlys