LIQUIDATED DAMAGES

Introduction

A liquidated damages provision fixes the sum payable as damages for a party’s breach and acts as a liability cap.  In a construction context, when a project suffers critical delay, the losses arising from late completion in some instances may be greater than the amount that the principal is entitled to claim as liquidated damages.  These losses may include the ongoing costs to the principal such as interest on borrowings, financing rollover fees, additional consultant fees and other prolonged overheads.

This article considers a principal’s entitlement to general damages where its actual delay losses exceed the amount of liquidated damages specified in the contract.  In summary, the prevailing (but not settled) view is that liquidated damages are a binding and exhaustive remedy for delay, and general damages cannot be claimed in addition or as an alternative.

This article also discusses some situations where the liquidated damages are unenforceable.  On this, I discuss, first, whether liquidated damages can amount to an unenforceable penalty.  Then, I discuss whether a liquidated damages provision may be treated as an exclusion clause where there is a deliberate or reckless breach by a contractor.

Can the Principal claim general damages in addition to or as an alternative to Liquidated Damages?

In the leading New Zealand decision of Camatos Holdings v Neil Civil Engineering,^[1] the parties had both a general liquidated damages provision and an additional penalty clause, which allowed the principal to recover sums in addition to the liquidated damages as a penalty for late completion.  The High Court upheld the arbitrator’s ruling that the penalty clause was unenforceable, and the principal was restricted to the liquidated damages even though the actual losses exceeded that figure.  Given the unusual feature of this case in that the contract included both liquidated damages and penalty for delay, it should be noted that this authority may not provide a complete answer.

In contrast, in Mayor, Councillors, and Burgesses of Borough of Sydenham v Poore,^[2] the contract had a liquidated damages clause stipulating £1 for each case of negligence by the contractor in carrying out the works.  The contractors negligently and in breach of contract failed to light a cart, which resulted in the death of a member of the public.  The Court found that £1 “liquidated damages” sum was in fact a penalty and therefore unenforceable.  The contractor could not rely on the liquidated damages clause because the negligence in question did not come within the ambit of the provision, and if it did, £1 was clearly inadequate to meet the damages.  This decision was recently cited by in Concrete Structures (NZ) Ltd v Waiotahi Contractors Ltd where the High Court said in obiter “It is well-settled that general damages can be sought as a substitute for liquidated damages”. ,^[3]  In that case the Court was deciding whether there was an implied term in a subcontract that the subcontractor would be bound by the liquidated damages provision in the head contract.  This is fundamentally different to a situation where there is a liquidated damages provision but the rate is too low.

Australia has adopted a similar approach to that in Camatos.  In IPN Medical Centres Pty Ltd v Van Houten,^[4] the plaintiff claimed damages pursuant to the liquidated damages clause and sought general damages as an alternative, claiming that it had suffered a greater loss than the amount it was entitled to under the liquidated damages clause.  The Supreme Court of Queensland found that a liquidated damages clause acted as a liability cap.  A party could not ignore the contractually agreed damages and elect to claim a larger amount even where the liquidated damages in the contract were insufficient to compensate for the loss.

Similarly, in the English case of Pigott Foundations Ltd v Shepherd Construction Ltd^[5] the court held that the liquidated damages provision in a subcontract had the effect of imposing liability on the subcontractor to pay damages at the specified rate, and precluded the head contractor from seeking delay damages in excess of the liquidated damages rate.  The English courts made similar findings in Surrey Heath Borough Council v Lovell Construction Ltd,^[6] and Biffa Waste Services Ltd v Maschinenfabrik Ernst Hese GmbH.^[7]

The cases from other jurisdictions weigh heavily on the side of contractual liquidated damages being exhaustive and binding on the contracting parties.  That appears to be the approach in England even where the liquidated damages provision sets no rate at all.  The Court of Appeal in Temloc v Errill Properties Ltd^[8] found that a liquidated damages provision in a JCT standard building contract, which specified “£nil” meant that the parties had agreed there should be no damages for delayed completion.  It was said that the contract constituted an exhaustive agreement of the damages (whether liquidated or unliquidated) that were payable, meaning it was not open to the principal to claim general damages instead.

By contrast, the Supreme Court of Western Australia in J-Corp Pty Ltd v Mladenis^[9] more recently decided that inserting “Nil” did not exclude the principal’s right to claim unliquidated damages by reason of breach of the contract and stated that clear words are needed to rebut the presumption that a party does not intend to abandon any remedies arising by operation of law.  In similar vein, it was held in Sizer v Squarcini,^[10] that inserting “N/A” adjacent to the liquidated damages rate meant that the entire liquidated damages clause was “Not to Apply” and so the principal remained entitled to general damages for the delay.

In summary, the authorities overwhelmingly supports the view that where a positive amount of liquidated damages is set (however low), they are an exhaustive and binding remedy for delay and general damages cannot be claimed as an alternative.  The repeated theme in the line of authorities is that a liquidated damages provision fixes (by agreement) the damages payable upon a party’s breach and functions as a liability cap.  The courts are unlikely to interfere with the parties’ commercial decision unless one of the exceptions apply (which I consider next).

Can liquidated damages amount to a penalty and therefore be unenforceable?

Liquidated damages are generally enforceable unless it constitutes a penalty, i.e. not a genuine pre-estimate of loss.  Traditionally, the contractor would challenge liquidated damages as being excessively high compared to the likely loss sustained.  If a liquidated damages provision is held to be an unenforceable penalty, the principal is left to claim general damages and prove its actual losses.

Recently, the Courts in the UK and Australia have moved away from the traditional concept of “genuine pre-estimate of loss” as conceptualised in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd^[11] and instead adopted a wider “legitimate interest” test.^[12]  Under this test, a clause is considered to be a penalty where the detriment to the contract breaker was “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”.  The legitimate interest approach would be a significantly more difficult standard to meet.  This approach has been followed by the High Court in New Zealand in Honey Bees Preschool Limited v 127 Hobson Street Limited.^[13]  The appellate courts are likely to take the same approach if and when the issue reaches them, given the overseas developments and judicial reluctance to interfere with arms length bargains between commercial entities.

A question arises as to whether it is possible for a principal to argue that unreasonably low liquidated damages amount to a penalty against it.  Although New Zealand courts have not directly considered this issue, the High Court in Smith Developments Ltd v Dormer Constructions Ltd^[14] in obiter cited a Privy Council judgment which commented on the dangers inherent in such arguments, contending they do not address the correct test for whether a provision is a penalty (i.e. whether it is a genuine pre-estimate of loss).^[15]  In other words, the Privy Council doubted an appreciably low liquidated damages rate could be a penalty against the payee.

Australia has also considered and rejected this argument.  In Multiplex v Abgarus,^[16] it was held that a liquidated damages rate which is less than the actual damages is not unconscionable or a penalty: “[t]he true vice in [a penalty] clause is not that it is not a genuine pre-estimate of damage, but rather that it yields a result which exceeds that which a genuine pre-estimate of damage would have yielded.”  In most instances, the principal has ready access to the financial information about the losses it is likely to suffer in the event of delay, but may freely agree to a rate that is lower than commercially reasonable for sound commercial reasons.  As noted in Honey Bees, it is not the function of the penalties rule to protect commercially sophisticated parties from their commercial decisions.

In summary, there is little support for a principal contending that unreasonably low liquidated damages constitute an unenforceable penalty.  This makes sense from the public policy perspective – liquidated damages are intended to give parties certainty, and each must generally live with the bargain they have made.

Are the liquidated damages unenforceable for deliberate or reckless breaches?

Under the common law doctrine of “fundamental breach”, where one party to a contract has committed a fundamental breach, that party could not rely on an exclusion clause to avoid or limit its liability for the breach.

The “fundamental breach” doctrine has not been good law since the House of Lords decision in Suisse Atlantique Societe d’Armament SA v NV Rotterdamsche Kolen Centrale,^[17] which rejected the rule of fundamental breach and held that the question of whether and to what extent a party may rely on an exclusion clause was to be resolved by construction of the contract.  New Zealand courts have followed this approach and held that such provisions are to be given their natural meaning in light of the contract as a whole.^[18]

The upshot is that a serious or fundamental breach of contract may fall outside an exclusion clause, but this will not be an automatic outcome.  Instead, it will depend on the particular words and actions in each case.  To that end, a deliberate or reckless breach of contract will be relevant in deciding whether the parties contemplated that the particular breach would be excused or limited.  Further, any injustice to an innocent party by the application of an exclusion clause will normally be taken into account only in consumer cases where there is unequal bargaining power, or where public policy considerations plainly outweigh freedom of contract (e.g. criminal or fraudulent conduct).

An analogy could be drawn between traditional exclusion clauses (which seek to limit the liability of a party in certain events) and liquidated damages provisions (which seek to limit delay related damages to a fixed amount) to argue that the liquidated damages does not apply where a contractor’s conduct falls outside what was contemplated by the liquidated damages provision.  The House of Lords reached a different view in Suisse Atlantique – finding that demurrage for shipping delays under a charter was not a “limiting term”.  This issue has not been decided in New Zealand or in a construction context, meaning that there is at least an argument available that liquidated damages should be treated as an exclusion or limitation clause, and accordingly, that whether and to what extent a party may rely on it is a matter of construction of the contract.

In conclusion, there may be an argument available that a liquidated damages provision does not apply where the contractor’s conduct has been reckless or possibly deliberate.  However, there are a number of hurdles the principal would need to overcome in order to succeed with such an argument.

Conclusion

The preponderance of authorities in New Zealand and overseas hold that liquidated damages are a binding and exhaustive remedy for a contractor’s delay, meaning a principal is unlikely to be able to claim general damages in addition or as an alternative to this.

Principals should think carefully about what the actual delay costs might be and ensure that liquidated damages are proportionate to the principal’s legitimate interest in having the works completed on time.  Principals could also consider including a carve out that these will not apply for delay arising from a deliberate or reckless breach.  If no liquidated damages are to be specified (i.e. “$nil”), the best practice is to include explanatory terms as to whether this means no delay damages at all or that the principal may still claim general damages.

Contractors, on the other hand, may limit their exposure to general damages for delay by setting the amount for liquidated damages at a positive amount.  If liquidated damages are specified in a positive amount, both parties should expect to be bound by that bargain.