REUTERS | Jason Lee

A warning for contractors: don’t be complacent about high LDs

As I was recently sailing beneath a deep blue sky on a junk in the majestic Hong Kong Harbour, gin and tonic in hand, you may be surprised that I had the law on my mind – specifically, Azimut-Benetti v Healey. A dispute between the parties required the High Court to revisit the classic dichotomy between liquidated damages (LDs) and penalties. The fact that the case involved a contract to buy a rather expensive yacht may make this picture a little more understandable!

The boat builder, the buyer and the sea in between

As Alexandra Clough has previously commented on these pages, the judgment highlights an increasingly common recognition by the courts that a clause in a commercial contract that provides for payment of LDs on the occurrence of an event (such as breach of contract) may be neither a penalty nor a genuine pre-estimate of the loss likely to be suffered as a result – yet may still be enforceable. In these circumstances, provided the dominant purpose of the clause is not to deter a party from breach, the courts have been prepared to uphold the clause on the basis that it is commercially justifiable. This follows the courts’ reluctance to interfere with the commercial bargain struck between parties, particularly where they are of comparable bargaining power, as (for example) Alfred McAlpine v Tilebox illustrates.

Contractors are often faced with a “take it or leave it” choice when it comes to LDs – accept the job together with the LDs or don’t. Therefore, contractors will often take the job and deal with the potential consequences of LDs later. Often they reassure themselves that they won’t be delayed in completing their works or sometimes that the LDs are so excessive they surely cannot be a genuine pre-estimate of the loss likely to be suffered by the employer for late completion. A court, they might think, would surely find that the LDs were extravagant and unconscionable and therefore should be struck down as a penalty.

Yet, as contractors should be well aware by now, few cases exist where LDs have been rendered unenforceable as a penalty. Given this, a “deal with it later” approach to LDs has never been a sound commercial one.

However, with the increasing recognition of the commercially justifiable test, this approach is even more perilous. An employer may be able to demonstrate that, while the LDs clause in question may not be a genuine pre-estimate of the loss likely to be suffered from delay in completion, it is also not a penalty. Rather, it occupies a position in the breadth of the commercially justifiable “sea”, in the middle of the two extremes.

Remembering this at the contract negotiation stage is critical – otherwise the contractor’s arguments to a court or adjudicator may be well and truly scuppered.

4 thoughts on “A warning for contractors: don’t be complacent about high LDs

  1. One possible approach for contractors is to offer 2 prices – 1 on the basis of the LDs as asked for by the employer and a second price on the basis of lower LDs. It might make the employer reconsider….

  2. This post recession period, there are many contractors and not so many jobs under finalization. So, a Contractor’s bid needs to be fully compliant and unqualified; lest he is put out of race. Risk is inevitable to the Contractor; but how how deals with that is dependent on his knowledge and ability.

  3. The fact that LDs defined for a particular contract are “commercially justifiable” is often taken for granted by potential contractors, who have little room, if at all, to challenge the correctness of LDs rates. Observation No. 1 – it is not a standard practice to request justification from the customer for applicable LDs rates. Observation No 2 – risk sharing is not a commonly acceptable approach. Customers prefer transferring risks, which means that the contractor is left on his own to deal with issues which may give rise to LDs claim.

  4. Don’t ever acquiesce. Put in a competitive bid, but cap LDs at a maximum of 3.5% in full and final settlement of the liability of the contractor for delay.

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