Understanding Liquidated Damages in Commercial Contracts

Liquidated damages are pre-agreed, fixed monetary sums stipulated in a contract to compensate the non-breaching party for specified losses arising from a breach of specific terms. For example, in construction contracts, a common liquidated damages provision requires the contractor to pay the principal a fixed daily amount for each day the project is delayed beyond the contractual completion date.

They differ from general damages (which are assessed after a breach occurs) and from penalty clauses (which are unenforceable punitive provisions). Instead, liquidated damages clauses are a contractual fixed sum that is agreed upon before the relationship begins.

Liquidated damages clauses are commonly found in the following types of contracts:

• Construction contracts
• Master Service Agreements (MSAs), which provide a framework for ongoing business relationships
• IT Service Contracts, and
• Outsourcing Agreements and Service Level Agreements (SLAs).

Liquidated Damages vs Penalties

Liquidated damages are a not meant to be a penalty, but rather a “genuine pre-estimate of loss” to compensate the other party for the effects of the breach. In Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30, the High Court found that ANZ’s exception fees constituted unenforceable penalties because they were “out of proportion” to the legitimate interest being protected. Liquidated damages should not be punitive or impose an excessive burden on the breaching party. They must be reasonable compensation for a breach.

If there is a dispute that cannot be resolved internally, courts will assess whether the clause is a genuine pre-estimate of loss or whether it is out of all proportion to any legitimate interest of the party seeking to enforce it. Under Australian law, the burden of proof lies with the party alleging that the clause is a penalty.

Drafting Liquidated Damages Clauses

Therefore, to be enforceable, liquidated damages clauses have to be carefully drafted to avoid being struck down as penalties. The clause should be based on a genuine pre-estimate of the loss likely to be suffered, and it is advisable to document the basis for this estimate. Legal advice should be sought to ensure the clause is enforceable. The triggering events for liquidated damages must be clearly and specifically defined. For example, rather than simply stating ‘construction delays’, the clause should specify the milestone or completion date, the method of calculating delay, and any exclusions (such as delays caused by the principal or force majeure events). Without clearly defined breaches, it is impossible to make a reasonable estimation of losses, which increases the risk the clause will be deemed a penalty. Consider including a maximum liability cap to limit exposure and reduce the risk of the clause being challenged as excessive. If a dispute arises, legal advice can help assess the enforceability of the clause and facilitate negotiation between the parties to reach a resolution.

Ultimately, the appropriateness and content of liquidated damages clauses vary depending on the specific circumstances of each contract. If you have any questions about liquidated damages clauses in your commercial contracts, please do not hesitate to contact us for advice tailored to your specific circumstances.

DISCLAIMER: This article is for informational purposes only and does not constitute legal advice.