When are liquidated damages in reality a penalty and therefore not enforceable?

Liquidated damages are pre-agreed fixed damages payable by one party to another as a means of compensation for loss or damage suffered following a breach of a contract.

The breach triggering the payment of liquidated damages must be one which would normally cause damage to the party in whose favour the liquidated damages apply.

By agreeing to the amount or rate of liquidated damages, the parties agree at the time of entering into the contract, the rate at which damages will be payable following the occurrence of the identified breach.

Construction contracts often use liquidated damages.

If the party undertaking the construction works (the contractor) breaches the contract by failing to complete the construction works within the period or by the date required by the contract (i.e. by the date for practical completion) then the contractor must pay damages for that breach to the other party (the principal or developer).

Clause 34.7 of the construct only standard form AS 4000-1997 General Conditions of Contract provides:

If WUC does not reach practical completion by the date for practical completion, the Superintendent shall certify, as due and payable to the Principal, liquidated damages in Item 24 for every day after the date for practical completion to and including the earliest of the date of practical completion or termination of the Contract or the Principal taking WUC out of the hands of the Contractor.

Liquidated damages in a construction contract are usually expressed at a daily rate.

Item 24 of Annexure Part A of AS 4000-1997 stipulates the agreed rate of liquidated damages.

24

Liquidated damages, rate (subclause 34.7)

.................................................................................................... ......................................................................per day     $.......................................per day

Item 24 of AS 4000-1997 is where the parties record, at the time of entering into the contact, the pre-agreed fixed damages rate that will be payable by the contractor if the construction works do not reach practical completion by the agreed date for practical completion.

If a rate of liquidated damages is not specified in the contract, the principal or developer would be entitled to general damages (as it would for breach by the contractor of any of its obligations under the contract) if the contractor fails to bring the works to practical completion by the date for practical completion.

Liquidated damages vs general damages

The difference between liquidated damages and general damages is that:

• liquidated damages are a pre-estimate of damages agreed between the parties and expressly stated in a contract,

• a claim for liquidated damages does not require proof of loss – one need only establish the occurrence or non-occurrence of the specified breach, for liquidated damages to be payable,

whereas

• a claim for general damages requires proof of actual loss suffered; and

• general damages are amounts generally determined by the courts.

However the law does not allow a party to be required to pay a stipulated amount for breaching a contract that is a penalty (i.e. a punishment) rather than just compensation for loss or damage suffered by the innocent party.

A stipulated amount payable for breaching a contract will be a penalty where the purpose of the provision is not to compensate the innocent party for its loss but rather to penalise or punish the breaching party or to force the breaching party to perform its obligations for fear of having to pay the penalty.

At law, penalties in contracts are unenforceable.

However mere disproportion between the agreed rate of liquidated damages provided for in the contract and the actual or possible damage or loss suffered is not enough to indicate a ‘penalty’[1].

The courts have regularly observed and upheld that the freedom of parties to enter into a contract on agreed terms is important and accordingly the courts require good reason ‘to set aside the bargains upon which the parties of full capacity have agreed’.[2] 

The penalty doctrine is an exception to freedom of contract and accordingly for an agreed rate of liquidated damages to be judged to be a penalty it must be found to be ‘extravagant and unconscionable in amount’. It is not enough that it should be lacking in proportion. It must be ‘out of all proportion’[3] compared to the greatest loss which may be suffered.

The recent case of Growthbuilt v Modern

Liquidated damages are often resisted by contractors (including subcontractors under a contract with a head contractor) on the basis that the liquidated damages rate is a penalty and out of all proportion compared to the greatest conceivable loss that could flow from the breach.

This was one of the issues before the NSW Supreme Court in Growthbuilt Pty Ltd v Modern Touch Marble & Granite Pty Ltd.[4]

One of the questions before Justice Henry was whether a subcontract that provided liquidated damages at the rate of $3,500 per calendar day was unenforceable as a penalty.

Growthbuilt and Modern entered into a lump sum subcontract of $60,500 (excl) GST for the supply and installation by Modern of kitchen and laundry benchtops and splashbacks, cladding to walls and works to the pool.

Under the subcontract Modern agreed to execute and complete the works diligently, expeditiously and by the date of practical completion.

Modern contended that the liquidated damages rate of $3,500 per day was unenforceable as a penalty.

Modern submitted that there was no evidence to suggest that, at the time the subcontract was entered into, Growthbuilt would have anticipated that it would suffer any damage as a consequence of Modern’s delay in completion, with the consequence that the sum of $3,500 per day was plainly extravagant, out of all proportion, or unconscionable in comparison with the greatest loss that could have been anticipated to follow from Modern’s breach and delay to the completion of the subcontract works.

Modern, being the party claiming that the liquidated damages were a penalty, bears the onus of proof.

Justice Henry held, on the evidence before the Court, that Modern had not persuaded him that the pre agreed stipulated rate of liquidated damages of $3,500 should be characterised as “extravagant, out of all proportion or unconscionable” compared to the greatest loss which may be suffered by Growthbuilt’[5].

His Honour ordered Modern to pay Growthbuilt liquidated damages for 122 days at the rate of $3,500 per day for a total sum of $427,000.

Care must be taken by the principal to a construction contract (or the head contractor to a subcontractor) not to demand a rate of liquidated damages which may be judged as being ‘extravagant, out of all proportion, or unconscionable’ and therefore at risk of being challenged and subsequently judged to be a penalty.

Equally, the contractor (or subcontractor to a subcontract) must give due consideration to the agreed rate of liquidated damages stipulated in the contract and fully understand which causes of delay to the works will entitle the contractor to an extension of time to complete the works (and thereby avoid paying liquidated damages) and which causes of delay will not.

Reach out to Bartier Perry’s team of experienced construction lawyers who are ready and available to assist principals and contractors with the implications and negotiations of the terms of the construction contracts and with resolving any issues that invariably arise during the carrying out of the works.

If you have any questions relating to this article, please contact David Creais.

Author: Mark Glynn

Contributing partner: David Creais

 

[1] Paciocco v Australia and New Zealand Banking Group Ltd (2016)  [2016] HCA 28

[2] Ringrow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71 at [32]

[3] ibid

[4]Growthbuilt Pty Ltd v Modern Touch Marble & Granite Pty Ltd [2021] NSWSC 290

[5] ibid at [111]