Delay and Disruption - Liquidated Damages Clauses

© Daniel Atkinson 2006 1 July 2006

PRACTICE NOTE

Liquidated Damages (LD) Clauses in contracts avoid the legal hurdles of proving actual loss as a result of a breach of contract and the rules as to remoteness of damages.  LD clauses can benefit the contractor since he knows his level of liability for the particular risk and benefits the Employer through reduced bids.
The Employer must aware that if the level of LDs is less than the loss likely to occur, the effect of the LD clauses is to transfer the risk of the shortfall to the Employer.

Damages is one of the most important remedies for breach of contract in the construction industry, but requires two significant legal hurdles to be overcome before there can be recovery. First the injured party must prove he has incurred actual loss as a result of the breach. Secondly the loss must not fall foul of the legal rules as to remoteness; Hadley -v- Baxendale (1854); Victoria Laundry (Windsor) Ltd. -v- Newman Industries Ltd (1949).

These rules prevent recovery of losses which arise from special circumstances, unless the circumstances are known and there is an implied acceptance that the contract was directed to these special circumstances. In practice this means that the injured party is faced with expensive legal action if he is to obtain compensation.

LD clauses in a contract avoid these legal hurdles. Just as the parties at the time of contracting can agree their obligations under the contract, so they can agree the amount of compensation to be paid if the particular obligation is not performed. There is no need to look for an implied agreement to compensate for losses due to special circumstances. The liquidated damages clause is an express agreement, so compensation is payable whether or not the special circumstances which make the loss likely are known. In other words the parties are not bound by the rules as to remoteness for the particular breach specified; Robophone Facilities, Ltd -v- Blank (1966) 3 All ER 128 CA.

By this mechanism of LD clauses, disputes are either avoided altogether or if there is a dispute the cost involved in proving damages is avoided. A liquidated damages provision is therefore commercially very attractive to both parties, since it avoids the need to ascertain the quantum of damages. In Robophone Facilities Limited v Blank [1966] 1 WLR 1428 in the Court of Appeal in relation to a liquidated damages clause in a hiring contract Diplock LJ said:

"I see no reason in public policy why the parties should not enter into so sensible an arrangement under which each know where they stand in the event of a breach by the defendant, and can avoid the heavy costs of proving the actual damage if litigation ensues."

The mechanism of LD clauses also allows the Contractor to know when he tenders precisely the level of his liability for the risk inherent in the particular obligation and hence may allow the contractor to reduce the level of his bid, which is to the advantage of both parties. Lord Woolf in Philips Hong Kong Ltd -v- The Attorney General of Hong Kong (1993) stated:

"Since it is to their (the parties) advantage that they should be able to know with a reasonable degree of certainty the extent of their liability and the risk which they run as a result of entering into the contract. This is particularly true in the case of building and engineering contracts. In the case of those contracts provision for liquidated damages should enable the Employer to know the extent to which he is protected in the event of the contractor failing to perform his obligations."

The effect of the mechanism of LD clauses in reducing a bid benefits the purchaser only if the extent of the risk which materialises is not greater than allowed for in the liquidated damages clause. If not, then the liquidated damages clause will have had the effect of passing part of the risk of the particular event from the contractor to the purchaser.

In the Court of Appeal in Bath and North East Somerset District Council v Mowlem plc [2004] EWCA Civ 115 it was observed:

"Whatever they may be and whatever the terminology used to describe the sum, it cannot be assumed that the parties either regarded or agreed it as the measure of the full loss likely to be suffered or recoverable at common law, apart from their agreement. The parties may well, for commercial reasons, have concentrated on and covered only certain easily quantified items of cost ……. Or they may deliberately have agreed to limit the financial loss recoverable.

‘It was open to the parties to agree what they liked provided it did not amount to a penalty’:

see Temloc v. Errill Properties Ltd. (1987) 39 BLR 30 (CA), 35 per Croom-Johnson LJ, who referred to the possibility that liquidated damages might be agreed at the rate of £1 a week, or even (as was held to be the position in that case) to “£ nil” per week.”

If a contractor wishes to pass to a sub-contractor the risk under the main contract of paying liquidated damages, he may choose to do so either by a sub-contract liquidated damages clause or by giving the subcontractor notice of the provisions of the main contract. In the latter approach, the rules of remoteness above will require the Subcontractor to acknowledge that any breach by the Subcontractor which may result in breaches by the Contractor under the main contract and other contracts made in connection with the main works, and that the consequent damages, including liquidated damages payable, are within the contemplation of the parties.