Liquidated damages in construction contracts: Enforceability and common disputes

Project delays are a common challenge in many construction projects across Australia. These delays not only push back the original practical completion date but also lead to disputes over financial repercussions and the legitimacy of the delay itself. For parties involved in a project, it is crucial to understand how liquidated damages clauses operate and the disputes it can trigger.

A liquidated damages clause represents a pre-agreed mechanism by which the contractor compensates the principal for failing to complete the project by the agreed date for practical completion. It offers a predictable way to manage delays without requiring the principal to prove actual damages in court and provides contractors with clear visibility of their potential liability for late completion.

This article explores the factors that affect the legal enforceability of these clauses and common disputes between principals and contractors over its application. 

What makes a liquidated damages clause enforceable?

For a liquidated damages clause to be enforceable, it must be carefully drafted to reflect a genuine attempt to quantify the principal’s anticipated losses and clearly define the conditions under which the damages apply. This can be achieved by considering the below factors.

A genuine pre-estimate of loss

The fundamental legal requirement is that the liquidated damages amount must represent a genuine pre-estimate of the loss the principal is likely to suffer if the contractor fails to complete the project on time. This estimate must be made by both parties at the time the contract is formed. Factors to consider include:

• potential loss of revenue – the anticipated loss of earnings due to the delay
• financing costs – additional interest payments or holding costs incurred by the principal due to the delay
• supervisory costs – ongoing site supervision or project management expenses borne by the principal.

If the clause is intended to punish the contractor rather than compensate the principal for reasonably anticipated losses, it could be deemed an unenforceable penalty.

Clear and certain terms

In addition to a genuine estimate, the clause should also clearly define the conditions under which liquidated damages apply and how they are calculated. Key aspects include:

• trigger for liquidated damages – failure to achieve practical completion by the agreed date (as adjusted by extensions of time under the contract)
• rate of liquidated damages – the daily monetary rate to be applied for each day of delay
• caps and limitations – any maximum aggregate amount or the total liquidated damages the principal can claim
• interactions with extensions of time (EOTs) – how EOTs affect the calculation and applicability of liquidated damages, ensuring they only apply to unexcused delay.

What are the common arguments against liquidated damages?

Contractors often challenge the enforceability of liquidated damages clauses based on various arguments. We look at some scenarios below.

Not a genuine pre-estimate

This is the most common argument we see. In this situation, the contractor claims that the liquidated damages amount in the contract was arbitrary, excessive or not based on a reasonable assessment of the principal’s anticipated loss (due to delay in completing the project) at the time the contract was formed. To support this, the contractor may present evidence such as:

• industry benchmarks – prevailing market rates or industry standards for liquidated damages in similar projects
• principal’s assessment – analysis of the principal’s internal calculations (or demonstrate the lack of any assessment) used to determine the liquidated damages amount
• disparity in actual loss – proof that the principal’s actual financial loss incurred due to the delay was significantly lower than the damages amount specified in the contract.

Penalty argument

The contractor may claim that the liquidated damages amount was not a reasonable pre-estimate of potential losses but rather a contractual mechanism designed to penalise them for failing to meet the completion date.

Extension of time (EOT) issues

Disputes often arise in relation to EOTs, typically in the following ways:  

• principal’s assessment of EOTs – claims that the principal failed to correctly evaluate and grant valid EOT claims, leading to disputes over whether the contractor was entitled to additional time to complete the project
• concurrent delays – circumstances where both parties contributed to the overall delay
• contractual ambiguity – vague or unclear wording in the EOT clause, particularly regarding its relationship with liquidated damages, can create uncertainty and lead to disputes over the proper calculation and associated costs.

Prevention principle – when the principal’s actions cause delay

A contractor may argue that the principal’s actions or inactions prevented them from achieving practical completion by the agreed date. If the contractor can demonstrate that the principal’s actions or failure to act impeded their progress, the principal’s entitlement to claim liquidated damages may be reduced or negated entirely.

For example, a principal instructs significant changes to the design or scope of work after construction has commenced. These changes require the contractor to perform additional tasks, rework completed elements and alter the planned sequence of work. If these variations add to the project’s duration and the contractor is not granted a corresponding EOT, the contractor could argue that the principal ‘prevented’ them from completing the works by the original date. If the contractor’s argument is successful, the original completion date may be deemed unenforceable and ‘time set at large’. ‘Time at large’ means the original project completion date is no longer valid. This happens when the owner (principal) causes delays, and the contract does not allow for an  (EOT).

Best practices for drafting and enforcing liquidated damages clauses

To mitigate the inherent risks and potential for disputes surrounding liquidated damages, principals and contractors should adopt a proactive and collaborative approach from the outset of a project. The following best practices can enhance the enforceability of a liquidated damages clause:

• conduct thorough due diligence: Principals should carefully assess potential losses and document itemised calculations that support their liquidated damages estimates. This document will be critical in demonstrating that the agreed-upon amount represents a genuine pre-estimate of loss, a fundamental requirement for enforceability
• promote transparency and negotiation: Openly discuss liquidated damages during contract negotiations to ensure the contractor understands and agrees with the amount. This transparency can encourage trust and ensure that the contractor knowingly agrees to the potential liability. Avoid a ‘take it or leave it’ approach to reduce the likelihood of future challenges to the liquidated damages clause
• ensure clear and unambiguous drafting: Use precise language in the liquidated damages clause and its interaction with other relevant clauses (i.e. EOTs, variations, etc.). Ambiguity in these areas is a breeding ground for disputes
• administer the contract properly: Ensure timely and accurate assessment of EOT claims and clear communication regarding delays. Consistent communication regarding project progress and any potential delay is important in preventing misunderstandings that could lead to disputes over liquidated damages.

Key takeaways for principals and contractors

Although liquidated damages clauses are intended to provide a clear and pre-determined mechanism for addressing the financial consequences of projects delays, their enforceability is not automatic. These clauses frequently face challenges regarding their excessive and punitive nature, EOT issues, and the prevention principle. Ultimately, a collaborative and well-informed approach between principals and contractors is crucial to ensure the fair and effective application of liquidated damages, supporting smoother project delivery.

If you require legal advice on any liquidated damages clauses or have questions about this article, please get in touch with us here. 

Disclaimer
The information in this article is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this article is accurate at the date it is received or that it will continue to be accurate in the future.

Published by:

Jonathan Usher

Annie Lin

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