The cases for “Liquidated Damages” or “Commercial Justification”
Regardless of the type of commercial contract – construction, corporate, real estate, healthcare and even charter-party, the potential for a breach of contract by either party is always (or should be) in the minds of both parties before signing the contract.
For the knowledgeable employer and indeed contractor, the potential for a breach can be accommodated within the contract to avoid the termination of the contract. This is where a liquidated damages clause comes in.
This is a clause where a defaulting party pays a sum to the aggrieved party where the defaulting party has not attained a contractually agreed performance standard which will prevent the termination of the contact. Repudiation or termination of a contract can have enormous financial cost implications for both parties. The aggrieved party will still always suffer through legal costs regardless of a judicial decision in its favour.
So what are Liquidated Damages?
“Liquidated damages” is a recognisable and legal term within a contract to prevent the aggrieved party from bringing a claim for breach of contract and termination. Previously agreed damages are paid to compensate the aggrieved party and the contract continues.
It has long been established law that agreed liquidated damages MUST be a “genuine pre-estimate of anticipated losses” by the aggrieved party. In a simple employer/contractor scenario where the default is likely to be from the contractor, the employer must calculate its potential loss prior to contract in the event that a performance standard is not met. The employer may have other connected third party agreements which still need to be performed or commercial objectives to achieve for which the employer may have ensuing financial liabilities.
The employer must be wary though. Any attempt by the employer to make a profit from the failure to perform by the contractor may be considered as a penalty against the contractor rather than a genuine pre-estimate of loss by the employer. Penalty clauses will not be enforced by the Courts – rendering the clause void. Whether this will result in voiding the contract depends on the weight of the clause. Usual legally costly damages will still be available. THEN THERE IS COMMERCIAL JUSTIFICATION.
Advantages of Liquidated Damages
The parties recognise prior to contract that certain performance requirements are an essential part of the contract. Liquidated damages will therefore:
- ensure that the employer does not need to revert to the Courts to claim a breach of contract – saving legal costs all round;
- permit the employer to serve a notice on the contractor to deduct sums from any payments due to the contractor or conversely require the payment of sums by the contractor;
- allow the contract to continue, permitting the contractor to remedy its under-performance; and
- can be linked to a clause to incentivise the contractor to perform its obligations in excess of the required agreed standard.
General damages following a failure of a liquidated damages clause may ensue, but this is not for this article.