By Shanti Davies
Associate, Simpson Grierson
Liquidated damages must be a ‘genuine pre estimate of loss’ to be enforceable. Myth or reality? Despite this widely recited mantra, largely myth.
It is often stated that in the absence of such a ‘genuine pre-estimate’ liquidated damages clauses will be struck down by the courts as being penalty clauses. Not so. The reality is that more often than not these types of clauses are upheld by the courts which tend to respect the sanctity of freedom to contract (event the freedom to contract foolishly or unreasonably) over an intrusive approach.
We take a look at some of the myths and realities of liquidated damages.
Use of liquidated damages in the construction contract
The use of liquidated damages in construction contracts allows the parties to agree in advance on the damages that will be payable by the contractor if they breach certain obligation owed to the principal under the contract. The most common being damages for failure to meet the obligation to complete the works by the contractual due date for completion.
Despite their frequent use in the construction industry, there is uncertainty over how such clauses will be applied in the event of a dispute. Courts have discretion to not apply clauses specifying liquidated damages where they act as a "penalty" against the party in breach. However, they will typically not exercise this discretion solely to relieve a contractor of having to pay an award of damages that exceed, sometimes substantially, an owner's loss.
Are liquidated damages required to be a genuine pre-estimate of the loss?
While courts still often repeat the rule that the sum specified in a contract for liquidated damages must be a ‘genuine pre-estimate’, in their judgments the reality is that the outcomes of these cases often to do not follow the mantra.
This lack of close scrutiny into the existence or otherwise of a ‘genuine pre-estimate’ seems to be due to a growing reluctance on the part of courts today to interfere with the contractual dealings of the parties.
This reluctance to interfere is illustrated by the comments from a number of courts throughout the 1980s and 90s. For example, in the mid-1980s, the Australian Court of Appeal in the case of AMEV-UDC Finance v Austin complained about courts' attempts to restrict the damages available to plaintiffs seeking to enforce provisions for liquidated damages. The court urged judges to give the parties greater latitude to determine for themselves the terms of their contract. This would provide greater certainty of contract by allowing the parties to determine their rights and liabilities on breach and to agree in advance on damages in situations where the potential losses might be difficult or impossible to quantify.
This judicial attitude was not new and had been expressed earlier in the 1960s by the English Court of Appeal in the case of Robophone Facilities v Blank, which commented that there was no public policy reason why parties should be prevented from entering into arrangements precisely stating what their positions would be in the event of a breach of contract.
Throughout the 1990s and into the 21st Century courts have continued to express the view that they will not interfere with the parties' freedom to contract, except in limited circumstances.
When will liquidated damages not be upheld?
Despite their general policy of non-interference, courts may decline to apply clauses for liquidated damages where they consider such clauses will act as a 'penalty' against the party in breach. Circumstances where this discretion will be exercised however are narrow and generally confined to situations where: a) the sum specified in the contract is extravagant when compared with the loss likely to be suffered by the plaintiff; and b) where enforcing a provision for liquidated damages would be unconscionable.
How do the courts in New Zealand regard liquidated damages?
The New Zealand courts have essentially followed the same approach to liquidated damages as the courts in other Commonwealth countries like England, Australia and Canada. For example, in the case of Benjamin Developments Limited v Robert Jones (Pacific) Limited, Justice Henry of the Auckland High Court observed that the modern day trend, which he agreed with entirely, was to put more emphasis on the sanctity of contractual provisions over consideration of whether the sum was in fact a genuine pre-estimate of the likely loss.
The most recent full pronouncement of the law in New Zealand on liquidated damages in construction contracts comes from the case of Smith v Dormer, a 2006 decision of the High Court. The court noted that a provision for liquidated damages will not be a penalty or unconscionable solely because the loss suffered might be less than the sum payable as liquidated damages thus creating a "cash windfall" for the owner.
The court held that it could not be said that the sum for liquidated damages was not a genuine pre-estimate of the loss. However, the fact that the owner (Smith) had given an assurance to the contractor (Dormer) that liquidated damages would be minimised if the remedial works were completed without delay (which they then were) would have made it unconscionable for the owner to take advantage of the prompt attention to remedial works and abandonment of a claim for additional payment and then claim liquidated damage. Thus the court declined to enforce the clause for liquidated damages.
The trend of modern day courts is increasingly toward a policy of non-interference when it comes to litigation over liquidated damages. The comments by judges in recent cases suggest that the only remaining proper use of the penalty rule for striking down liquidated damages is to provide relief against oppression or unconscionable behaviour.
So contractors beware – even if the liquidated damages sum is an overstatement of possible losses, if you agree to it, you are likely to be stuck with it.
Contractor Vol.34 No.3 April 2010
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