Drafting Damages and Penalty Clauses

A paper for Legalwise Seminars 13th March 2014 in Adelaide

Introduction

1. The purpose of this paper is to consider drafting issues which arise where it is intended to fix a periodic rate ($x per day, or per week) where one or other party is late in relation to a construction contract.
2. There are numerous traps in this area, and in order to achieve effective contract drafting, it is necessary to consider a number of common law principles which are applied.

Terminology

Damages

1. The use of the term ‘damages’ in this context is often a misnomer.  The concept of damages is of course well understood by lawyers.  There is compensation payable pursuant to law as a result of breach of a contractual law tortious obligation.  However, in the context of the expressions ‘liquidated damages’ and ‘delay damages’ the concept being evoked is that of damages flowing from a breach of contract, but rather sums payable pursuant to the express terms of a contract in certain circumstances.  The distinction here is not so much to do with what triggers these payments, but rather the nature of the payments themselves.

Delay Damages

1. The expression ‘delay damages’ is usually used to describe sums payable under a contract to a contractor in the event of events which entitle the contractor, not only to an extension of time for completion of the work, but also for financial compensation.  As a matter of analysis, these damages are a species of liquidated damages, but are never referred to as such, that expression being reserved to sums payable to a principal by a contractor where the contractor is in delay.
2. All sorts of formulae are used.  Sometimes the delay damages are pre-agreed at $x per day, or per week.  Sometimes they are left at large, being whatever loss is actually suffered by the contractor.  Sometimes they are a combination of the two, for example, the contractor’s actual loss subject to a cap of $x per day or per week.

Penalties

1. The terms ‘penalties’ and ‘penalty clauses’ are often used by laymen, and by lawyers in the United States, to describe liquidated damages provisions, that is to say arrangements whereby the contractor, if late in completing the work, or sometimes individual separable portions of the work, by the agreed dates, as extended by the extension of time provisions, then the contractor must pay the principal at the rate of $x per day, or per week.  Lawyers in the common law tradition, however, draw a sharp distinction between liquidated damages clauses (which are lawful and prima facie enforceable) and penalty clauses (which are illegal and unenforceable) (see below).

Closing the Escape Routes for Liquidated Damages

1. There has been many cases where contractors have been able to escape the intended effect of a liquidated damages clause.  Some, but not all, of these escape routes can be closed down by careful drafting.

Liquidated Damages v Penalty Clause – Where is Dunlop Now?

1. In 1915, the law on this topic was crystallised by Lord Dunedin in Dunlop Pneumatic Tyre Co v New Garage and Motor Co [1915] AC 79.  The relevant passage has been cited many times:  Its key elements are:

• The essence of a penalty is the payment of money stipulated as in terrorem of the offending party whereas the essence of liquidated damages is a genuine covenanted pre-estimate of damage.
• The test is applied as at the time of the contract, not at the time of the breach.
• The use or words ‘penalty’ or ‘liquidated damages’ is not conclusive.
• The useful test is whether the sum stipulated for is extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to have flowed from the breach.
• It is no obstacle to a liquidated damages clause that precise pre-estimation is almost an impossibility; on the contrary, that is just the situation when it is probable that the pre-estimated figure was the true bargain between the parties.

1. Over the last hundred years, there has probably been some implicit tendency for the courts to become less attracted by arguments that a particular clause is penal.  Thus the courts have said:

• That the onus of showing that the clause is a penalty clause lies with the party who is potentially liable on it; Robophone Facilities v Blank [1966] 1WLR 1428 at 1447.
• A genuine pre-estimate does not have to be an honest pre-estimate at Murray v Leisureplaw [2005] EWCA Civ 963 at [111].

1. In Alfred McAlpine v Tilebox [2005] BLR 271 it was held that a clause was not penal where it was most unlikely, although just conceivable, that the actual loss could be as high as the stipulated figure.
2. Further, there has been some express declaration of a more laisser faire approach.  In Amev-Udc Finance Ltd v Austin[1] the High Court said:

41. Instead of pursuing a policy of restricting parties to the amount of damages which would be awarded under the general law or developing a new law of compensation for plaintiffs who seek to enforce a penalty clause, the courts should give the parties greater latitude to determine the terms of their contract. In the case of provisions for agreed compensation and, perhaps, provisions limiting liability, that latitude is mutually beneficial to the parties. It makes for greater certainty by allowing the parties to determine more precisely their rights and liabilities consequent upon breach or termination, and thus enables them to provide for compensation in situations where loss may be difficult or impossible to quantify or, if quantifiable, may not be recoverable at common law. And they may do so in a way that avoids costly and time-consuming litigation. But equity and the common law have long maintained a supervisory jurisdiction, not to rewrite contracts imprudently made, but to relieve against provisions which are so unconscionable or oppressive that their nature is penal rather than compensatory. The test to be applied in drawing that distinction is one of degree and will depend on a number of circumstances, including (1) the degree of disproportion between the stipulated sum and the loss likely to be suffered by the plaintiff, a factor relevant to the oppressiveness of the term to the defendant, and (2) the nature of the relationship between the contracting parties, a factor relevant to the unconscionability of the plaintiff’s conduct in seeking to enforce the term. The courts should not, however, be too ready to find the requisite degree of disproportion lest they impinge on the parties’ freedom to settle for themselves the rights and liabilities following a breach of contract. The doctrine of penalties answers, in situations of the present kind, an important aspect of the criticism often levelled against unqualified freedom of contract, namely the possible inequality of bargaining power. In this way the courts strike a balance between the competing interests of freedom of contract and protection of weak contracting parties

1. There is no single formula as to what will be regarded as a genuine pre-estimate.  Typical and acceptable calculations include:

• Where the project delivers a capital value, the financing cost of that asset.
• Where the project is for a facility which produces saleable commodities (eg oil, groceries etc) the net profits that are anticipated.
• Where the project produces an asset which will be rented out, an estimate of the likely rent.

1. Substantial penalty issues sometimes arise where the clause addresses, not completion or the project as a whole, but the achievement of milestones in the construction process.  These sorts of provisions are potentially problematic where the principal is unable to show any expectation of loss merely because such a milestone might be missed.

The Other Way Around – Bonuses

1. What should a principal do if she wants to wield a figure fixed than permissible under the Dunlop v New Garage doctrine?  One approach is to draft the clause the other way round:  Instead of providing for liquidated damages if the project is late, the contract might provide for a bonus to be paid if the project is early.  Provided that the completion date is adjusted accordingly, the commercial result may well be precisely the same.
2. Example
3. Suppose for example a contract for $100 million to be completed in 10 months, with liquidated damages of $1 million per month capped at $10 million. The calculation will look like this:

Now suppose the contract price is put at $90 million with a date for completion in month 20. Instead of liquidated damages, the contractor is offered a bonus of $1 million per month is he finishes early, subject to a maximum of $10 million. Now we have:

The net payable is the same either way.

 

Damages for Loss of a Chance

1. A word of caution, about bonuses.  Principals sometimes draft bonus clauses without taking into account that the bonus might, in effect, be payable even though the target date is not achieved.  Thus, if the contractor would have achieved a target date, entitling it to a bonus, but for a breach of contract by the principal, then the damages payable by the principal for that breach was prima facie include the bonus which the contractor has thereby lost.  Sometimes, a part of the bonus may be recoverable if the contractor is able to show no more than the loss of a chance of obtaining the bonus.[2]

Or…Lane Rental Deals

1. Another approach is that adopted by lane rental contracts, which were originally developed by Government Agencies in the UK engaging contractors to maintain public roads, and who wanted to powerfully incentivise the contractors to complete the maintenance work as quickly as possible, and with as little disruption as possible to the traffic.  The lane rental solution is to charge the contractor a daily rental for each lane of the road that the contractor closes to traffic, and to build that rent into the contract price, on the basis that the rent is deducted from each progress payment[3].
2. The idea is that the periodic payment is not characterised as compensation for breach at all, but as rent, payable under the contract.  In the past, this distinction was vital: the doctrine of penalties only applied to payments prescribed in the event of a breach of contract[4]. Now, following the High Court decision in Andrews v Australia and New Zealand Banking Group Limited [2012] HCA 30 there is more of a question mark hanging over that question, and cases need to be considered on their individual facts:

78.       The upshot is that the restrictions upon the penalty doctrine urged by the Court of Appeal in Interstar should not be accepted. The primary judge erred in concluding, in effect, that in the absence of contractual breach or an obligation or responsibility on the customer to avoid the occurrence of an event upon which the relevant fees were charged, no question arose as to whether the fees were capable of characterisation as penalties.

Prevention & Time at Large

1. Liquidated damages are, of course, applied to the period during which the contractor is in excusable delay, that is to say taking into account the extent to which the contractor is entitled to extensions of time to complete the work.
2. It is generally a bad mistake for principals to unduly restrict, or even remove, the usual ground for extension of time, because of the doctrine of time at large.  If the contractor can show that he has been prevented or impeded from achieving completion by reason of an act of the principal for which there is no entitlement to an extension of time, then the legal consequences that the whole of the time     ?      , including the liquidated damage provision, is shattered.[5]

Security of Payment

1. The Building and Construction Industry Security of Payment Act 2009 (SA) presents real challenges to contract advancement.  The real difficulty arises as a matter of practice rather than as a matter of law:  Many adjudicators will as a matter of training and approach simply disregard a principals entitlements to liquidated damages in making determinations as to entitlement to payment claims.  As a matter of law, it is probable that this is wrong, but the conventional approach has been that mere errors of this sort by adjudicators did not invalidate their determinations.
2. The mood, however, has been changing, as courts become more and more critical of adjudicators determinations, and following Chase Oyster Bar v Hamo Industries there are signs that errors of law might invalidate adjudicators determinations.
3. As a matter of drafting, the best approach for a principal is probably to bill for liquidated damages into the calculation of the sum due under the contract.  In other words, the liquidated damages are treated, not as a deduction which the principal is entitled to set off against the right to payment, but rather as an integral part of the calculation of what is due under the contract.

The use of Caps on Liquidated Damages

1. It is not uncommon to see caps on liquidated damages, and in many cases a contractor or a sub-contractor will justifiably say that they are unable to afford the risk of unlimited liquidated damages exposure.
2. There is, however, a problem in commercial terms with simple caps.  Once the contractor has reached the cap, the contractor has no incentive at all to complete the work except his own standing overheads.  For this reason, better solutions might be:-

• Tapering provisions, whereby the periodic rate is highest in the early days of delay, and where the contractor is most likely to be responsive, and lowest if the delay continues.
• The more modern tendency is for progress payments to be calculated, not on the basis of the cost of the work done by the contractor from month to month, but rather by means of staged payments.  This mechanism of itself provides a powerful incentive for the contractor to complete, particularly if the amount payable on practical completion is a substantial percentage of the contract of the whole….

Delay Damages

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What if no clause?

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Delay on Damages Clauses as Exclusions

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Notice Clauses

The Court’s Antipathy

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Condition Precedent

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Parallel Damages Claims

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Breakdown of Contractual Machinery

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