April 24, 2013

A new way to look at the question of liquidated damages

If you procure building works you will want them finished on time. If the works are finished late it could mean you are unable to trade, or you lose a prospective contract. In short, late completion can cause major financial cost. In some circumstances delayed completion might be so serious that it might even undermine the whole commercial viability of a project or even a business itself.

Most businesses procuring building work seek to protect themselves from delay costs by imposing an “LAD”s provision on the contractor. “LAD”s is short for “Liquidated and Ascertained Damages” – a bit of a mouthful, so best just to stick with “LAD”s.

The idea behind LADs is that the employer and the contractor can agree in advance of any delay, what the rate of compensation is to be if the contractor is responsible for the works finishing late. If the works finish late the rate is simply multiplied by the number of days or weeks delay. It avoids a lot of time being spent trying to prove what the exact costs of the delay were.

WHAT IS A LEGITIMATE LAD’s RATE THOUGH? HOW SHOULD THE AMOUNT BE CALCULATED?

The danger for the employer has always been that if the rate is set too high it might not be enforceable. The courts would strike it down as being a “penalty”.

Until recently, the advice has been that the rate of LADs must be a genuine pre-estimate of the loss which would be incurred if the works were finished late. If the damages could be justified in this way then the clause would be valid and enforceable.  An employer was not expected to predict precisely what his losses might be, but as long as he made a genuine attempt to predict what the consequences of a delay might be then it did not matter if in fact the actual loss was a bit different.

A DIFFERENT APPROACH

Following the case of Cavendish Square Holdings BV v El Makdessi, however, the Courts are now adopting a more ‘modern’ approach. This case says that LAD rates  will be enforceable if they are “commercially justifiable”. If a contractor wanted to challenge the rate on the ground that it was an unenforceable penalty, it would need to demonstrate that:

  • There was no “commercial justification” for the LADs clause.
  • The clause was extravagant or oppressive.
  • The purpose of the clause was to “deter breach” rather than compensate loss.
  • The provision was not negotiated on a level playing field (if relevant).

With this new test in mind, a higher rate of LADs may be enforceable under this approach when it might have been unenforceable under the old approach.

EXAMPLE

To try to illustrate this, consider a scenario where a developer of a multi-storey apartment block anticipates a rental income per completed apartment. Under the old approach a genuine pre-estimate of loss might lead to an LADs rate which was linked to the anticipated rental income per apartment. However, this would disregard the negative effect on the chances of letting the completed apartments because of the ongoing presence of the contractor in the building.

Under the new approach it might be commercially justifiable for a higher rate of LADs to apply in respect of any substantial delay to full completion of the entire works (even if some of the apartments were or could be let in the meantime).

This would reflect the importance to the developer of having a fully complete building to showcase to prospective tenants with the increased likelihood that tenants would sign up. It potentially could mean that the employer made a double recovery in respect of any apartment which it had in the meantime managed to let out. The way the Courts are likely to deal with this, following the Makdessi case, is not to strike down the LADs clause, but instead to require the employer to give credit to the contractor for any actual double recovery.

THOUGHT AND CARE

Thought and care must of course still be taken when calculating the LADs rate. This new approach is not an invitation to introduce higher rates in all contracts. However some employers may have commercially justifiable reasons why the amount of LADs under a particular contract should be more than what a strict ‘genuine pre-estimate’ of a particular loss might be.

The benchmark of a ‘genuine pre-estimate’ still firmly has a place.  This remains a good way to show that the liquidated damages are not a penalty.  We recommend that this calculation is always the starting point. It is good practice to explain it to the contractor, and keep a record of how the figure has been reached. Often it is a matter for commercial negotiation – contractors will price for the level of risk they are being asked to shoulder, but if the rate hits a certain level the contractor may simply walk away from the deal.

If the particular commercial context creates a scenario where a higher level of liquidated damages is justified, then be prepared to explain why. If you can do this, satisfying the modern test, then there is now support from the Courts that this will be enforceable and will not be struck out of the contract on the grounds that it is a penalty. Remember that, above all, the courts try not to interfere with terms freely agreed and signed up to by parties.

If you would like more advice on this issue, or on the negotiation of construction contracts generally, please contact a member of the construction team.