Liquidated damages are like a safety net for construction contracts — they ensure projects stay on track even if things go off course. By setting clear penalties for breaches of contract, they encourage contractors to meet deadlines, while also protecting the owners from financial losses.
Here, we’ll discuss the basics of this type of damages and their practical application in the construction industry, among others. Stakeholders in construction contracts can find this article a useful resource. Lawyers can also share this as an educational piece for their clients.
What are liquidated damages?
Liquidated damages are pre-agreed damages specified in a contract, which shall be paid by the violating party in case of a breach or any other transgression.
The rationale for these damages works in two ways:
- it deters both parties from breaching the contract
- it secures compensation for the aggrieved or innocent party because of the breach
Also called stipulated damages or ascertained damages, these damages are recovered by the innocent party as an alternative to general or special damages. Not only will this simplify the recovery process for the aggrieved party, but it will also prevent any lengthy (and costly) litigation from happening.
These damages are usually viewed as contractual consequences for breaches, non-performance, or any other causes. However, they also work as compensation for the innocent party, especially when they experience grave losses due to that breach.
Putting up stipulated damages is usually done in construction contracts, aside from other commercial contracts where one of the parties must give or do something for the other. It’s usually inserted as one of the provisions on damages and penalties.
Watch this video for a general explanation on what liquidated damages are:
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How are liquidated damages used in different contracts?
While clauses on liquidated damages are widely used for construction projects, such stipulations are also used for commercial contracts. Oftentimes, they are also used in employment contracts executed at the time of the hiring date.
Liquidated damages in construction contracts
Liquidated or stipulated damages are widely used in construction contracts due to the large resources at stake in these transactions. There are various reasons why parties opt to agree to such stipulations, including:
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condition for contracting: project owners may want to protect their rights by requiring the contractor (and even up to their subcontractors) to agree on stipulated damages; otherwise, a contract will not be created between the parties
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ensure compliance: a construction contract will have several conditions, especially on the timeliness of the project, for which damages serve to ensure that these conditions are faithfully complied with
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for compensation: to simplify the process when a breach of contract happens, a construction contract can allow the project owner to collect damages, either on demand or not, and whether through judicial or out-of-court proceedings
Here’s a closer look on how liquidated or stipulated damages work in the construction industry:
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Used for construction delays
One of the common reasons why liquidated damages are imposed is to prevent, and at the same time serve as a legal remedy, for construction delays. Because of the importance of delivering the project on time in construction contracts, so much premium is put on the penalties for its breach — hence, the use of damages.
Here are some of the considerations when using these damages to prevent construction delays:
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amount of the actual losses: to decide on the amount of damages in a construction contract, parties will usually estimate the actual loss that the project owner may suffer because of the delay (e.g. lost income, additional construction costs, delayed loan payments)
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right to set-off: parties can negotiate and determine the terms of the damages, and one of those terms that can be included is a party’s right to set-off (e.g. when the guilty party is the contractor, liquidated damages may just be set-off from the payment that they’ll be receiving from the project owner)
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requirements for enforcement: another term that the parties can agree upon are the prerequisites that an innocent party should do before resorting to the enforcement of the liquidated damages clause (e.g. notice must be sent to the guilty party first, explaining the alleged delays, which will trigger the other provisions)
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scope of the delay: what constitutes "delay" must be clearly defined in the contract so that all parties can expect what types of delay are penalized and what are forgivable (e.g. parties can agree that a delay for specified months may still be remedied, but the succeeding delays will be subject to damages)
Liquidated damages in employment contracts
In another legal practice area, liquidated damages can be included in employment contracts, which may work in favour of either the employer or the employee. For example, these damages may be paid:
- to the employer: if the employee breaches the employment contract’s non-compete and non-solicitation clauses
- to the employee: if the employer engages in discriminatory practices and other violations against labour and employment laws
Can liquidated damages be challenged?
We usually see the guilty party as the one challenging a liquidated damages clause. However, there are also instances where it’s the innocent party who challenges it. In either case, the challenging party must prove that it should not be made applicable to the parties or when seeking any other relief from it.
Grounds for challenging liquidated damages
Below are some of the grounds that a party can rely on when challenging the validity or effectivity of a stipulated damages clause:
Excessive amount of damages
The guilty party, as a way of avoiding their liability on paying the liquidated damages, can challenge that the amount indicated is:
- excessive: that the amount is just too much
- unsubstantiated: that there’s no evidence that the damages are enough for the actual losses)
- unreasonable: that there’s no relation between the amount and the other party’s losses
Amount does not satisfy the actual losses
On the part of the innocent party, the stipulated damages may not be sufficient to cover the actual amount of losses they suffered due to the breach of contract. Here, the stipulation itself is not disputed; what’s being assailed is the amount in the stipulation. The innocent party will have to present evidence to prove that, on top of the amount of liquidated damages, the guilty party must pay additional money to wholly satisfy the loss.
Unconsented clause in the contract
By playing the defense of contract of adhesion, a party to a contract can assail its clauses on damages. They can allege that they did not understand the clause when it was entered into or that it was unexplained to them in clear terms.
Courts do not easily invalidate a liquidated damages clause. This is based on the principle that contracts are generally binding between the parties and that they should be followed as far as they have legal foundations to stand on.
But as with any other contract, along with its terms and conditions, it can be struck down by the court under legally sound arguments. Nevertheless, the overall structure of the contract and the circumstances of the parties will be surveyed by the court to decide whether to invalidate the contract or not.
Best practices for liquidated damages clauses
Just as with any other contract, the best way to approach liquidated or stipulated damages clauses is to have them neatly done in the first place. It must reflect the interests and rights of both parties right away, before any dispute arises.
For this, it’s proper to have legal experts, such as a building construction lawyer, deal with it. Most probably, the construction contract, which contains the damages clause, will be scrutinized by these professionals before it’s inked.
Amount must be proportional to the breach
With unreasonable amount as the most common cause of voiding a liquidated damages clause, great attention must be given when deciding the amount of damages. At least, it must not be too high to be exorbitant, nor too low to be unfair to the innocent party.
One thing that distinguishes these clauses on damages from other stipulations is that they must not be viewed as a penalty. To do so, parties may set a clear cap on the amount that can be claimed by the future innocent party.
Prevent the contract from becoming ‘adhesive’
Whether it’s a commercial, construction, or employment contract, it may be dubbed as a contract of adhesion. This works badly for the party who drafted it.
In a contract of adhesion, it’s acknowledged that there’s a power imbalance on the negotiating table. Examples of these are ‘take it or leave it’ instances, where the other party has no choice but to affix their signature. When a contract becomes one of adhesion, it may be held as unenforceable between the parties.
One of the things to look at in a contract to determine if it’s a contract of adhesion is the liquidated damages clause. If the stipulated damages are just too unfair, then it may not be enforced by the court.
It’s then important that it should not be ‘adhesive’ by clearly explaining the contract to the other party. If it’s a prepared, templated, or standardized contract, then the party who prepared it must ensure that the other party understands what is written before signing.
Considering putting up exempting clauses
To prevent the contract from being too punitive, parties can insert some contingencies, such as exempting clauses. This will minimize the negative effect to the guilty party, especially if the parties hope to continue the project even after some delays. Fpr example, a party may still be prevented from paying liquidated damages in cases of fortuitous events.
Liquidated damages: a safety clause in contracts
Liquidated or stipulated damages serve as a great tool in construction contracts; it offers clarity and security for both parties involved. By setting agreed-upon damages for delays or breaches, these clauses help ensure projects stay on track while minimizing the risk of lengthy construction disputes.
As such, parties to a construction contract must understand that these damages can help safeguard their interests by keeping projects running smoothly. Consulting with a construction lawyer can offer valuable guidance for the parties’ specific needs.
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