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If you work in the building and construction industry, or if you are engaging a builder or tradesperson, you may have encountered the term liquidated damages in your construction contract. These clauses are very important, and a failure to understand them could put you or your business at significant risk. This article explains liquidated damages in construction contracts, and outlines what you should look out for.

What are Liquidated Damages?

Construction contracts often use liquidated damages. It establishes the damages that the party undertaking the construction works (the contractor) must pay to the other party (the principal), if they fail to complete the works within the period required by the contract.

For example, a contract may provide that if a builder fails to complete the building by a certain date, the penalty under contract will be $10,000. Liquidated damages may also be a rate, instead of a fixed figure.

Usually, this period is the ‘date for practical completion’. Here, if the contractor fails to complete the works by the date for practical completion, they will be liable to pay liquidated damages to the principal.

Liquidated damages are predetermined damages. This means the parties calculate them before entering into the contract. The contract usually includes them in a dollar amount. For example, the liquidated damages rate could be $1000 per day/week.

The difference between liquidated damages and general damages (which parties pay for breaches of contract), is that:

  • liquidated damages are a predetermined fixed rate or amount stated in a contract; whereas
  • general damages are amounts the court determines.

Why Include Liquidated Damages in a Construction Contract?

To ensure the contractor completes your project on time, you may want to motivate them with contractual clauses. These will act as either a ‘carrot’ or a ‘stick’. Offering a bonus payment for completing works early would act as a ‘carrot’, or incentive. Liquidated damages would act as the ‘stick’, or the deterrent.

Although liquidated damages favour a principal, they also benefit the contractor. Liquidated damages allow the contractor to know exactly what they are liable to pay to the principal if they fail to complete the works by the date for practical completion. This is useful to assess potential cost and liability exposure under a contract.

Because it is difficult to consistently know what the courts will determine as damages, liquidated damages provide some certainty.

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How Do I Calculate Liquidated Damages?

Liquidated damages must be a genuine pre-estimate of the principal’s likely losses. These losses must occur due to the contractor failing to bring the works to practical completion by the specified date. You need to make this calculation before entering into the contract. This is instead of when the liquidated damages are actually payable by the contractor. As a result, the liquidated damages could be different from the actual losses that the principal suffers.

You cannot, however, add damages that are not a genuine estimate of loss. For example, if you engaged in a contract for the sale of three bouquets of flowers, but set the liquidated damages at $1 million, that is not a genuine estimate of loss and will not be honoured by the courts.

There is no set method or any specific rules to follow in calculating liquidated damages. Instead, it is necessary for the principal to consider their likely losses, on a case by case basis. You should not arbitrarily use the same liquidated damages rate across multiple contracts. This is because each project will likely have different risk exposure and estimated losses.

Calculation Considerations

If you are the principal, when calculating liquidated damages, you could consider including:

  • additional rent payments, if you are renting a different property to the property where a contractor is carrying out the works;
  • costs of insurances that you may have taken out specifically for the construction works and/or the project;
  • specific project costs (for example, administration or supervision staffing costs);
  • storage costs that are directly related to the delay. For example, if you need to relocate and store furniture or equipment during construction. This includes any new furniture which is awaiting delivery to the site, once constructed;
  • lost net profits as a direct result of the delay. For example, if you cannot operate your business during construction as a result of the delay; and
  • financing costs directly relevant to the project. For example, interest payable on a bank loan that you have taken out to fund the project.

It is a good idea to keep records of this calculation on any internal project file. This is in case the contractor challenges the rate of liquidated damages.

What if the Liquidated Damages Are Not a Genuine Pre-Estimate?

The rate of liquidated damages must be a genuine pre-estimate. If a court believes the rate is not genuine, it may regard the liquidated damages as a penalty. By law, penalties are generally unenforceable, which means that the contractor would not need to pay the liquidated damages.

Depending on the wording of the liquidated damages clause (see below), it could leave the principal without a remedy for the contractor’s failure to complete the works within the time required.

However, the onus is on the contractor to prove that the rate of liquidated damages is extravagant or unconscionable. This will make them a penalty and unenforceable.

How to Draft a Liquidated Damages Clause

If you are the principal, you will want to consider whether you intend for liquidated damages to be your only remedy if the contractor fails to complete the works on time. In other words, if a court deems the liquidated damages as unenforceable, you would still want the option to claim general damages.

If you are a contractor, you will want to make sure that liquidated damages are your only liability, should you fail to bring the works to practical completion within the period required by the contract.

When drafting a liquidated damages clause, particularly if you are the contractor, it is important to be explicit as to whether you intend for liquidated damages to be an exclusive remedy or not. Simply stating that liquidated damages are ‘not applicable’ or ‘nil’, or including a nominal amount such as ‘$0’ or ‘$1’ will not necessarily prevent the principal from claiming general damages.

Key Takeaways

Liquidated damages are predetermined damages in a contract that the contractor must pay to the principal if they fail to complete the works by the date for practical completion.

It is important for a principal to properly calculate a liquidated damages rate. This will avoid them being a penalty and therefore unenforceable.

When drafting liquidated damages clauses, ensure it is clear whether liquidated damages are the only damages payable by the contractor if they fail to complete the works on time.

If you need legal assistance with a building or construction project, including understanding liquidated damages, our experienced building and construction lawyers can help. Call 1300 544 755 or complete the form on this page.

Frequently Asked Questions

What is the benefit of a liquidated damages clause?

A liquidated damages clause will provide certainty for both parties as to what the damages will be if the contract is not completed. They also incentivise completion of the contract.

When will my liquidated damages clause be considered a penalty?

Your liquidated damages clause is a penalty if it does not reflect a genuine estimate of the loss that you would suffer if the contract is not completed on time.

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