Understanding liquidated damages in commercial contracts

When entering into a commercial contract, parties often include a liquidated damages clause to outline monetary compensation if there are delays or service level fallout or breaches. These clauses can provide contractual certainty and avoid costly litigation, but they must be carefully drafted to be enforceable. Here's what you need to know about liquidated damages in NSW commercial contracts such as 'Master Service Agreement' (MSA), Supply Agreement, Purchase Orders (Short Form Orders), and Contractor/Supplier's Deed of Supplier Agreement with government sector.

Liquidated damages are common in industrial supply contracts or engineering service industry of all types. Signatories in those commercial contracts are known as supplier, contractor, subcontractor to the buyer who have paid for the goods and/or services including engineering consultation project or industrial scale installation project/advice in professional industrial service sector. 

Our  commercial contract lawyers  at PCL can assist you with all types of commercial contract reviews, amendment, and negotiation. We can draft bespoke commercial clauses while protecting your business from liquidated damages claim,

What Are Liquidated Damages?

Liquidated damages are a pre-agreed sum set out in a contract, payable if one party breaches specific terms—most commonly, delays in project completion or delays in project milestones. They offer a clear way to determine compensation based on the formula incorporated as a liquidated damages in contracts.

For example, if a contractor/supplier fails to complete a project by the agreed deadline, the liquidated damages clause may require them to pay a fixed daily amount for each day of delay. This protects the principal/head contractor/buyer from financial loss due to delays, such as additional financing costs or lost revenue or intermittent termination of engineering project

Liquidated damages clauses are also known as 'agreed damages' or 'ascertained damages' while the unliquidated damages are 'unlimited' in nature and can be very costly especially for major service providers in engineering or supply projects.

Liquidated damages clause is triggered following the termination of the performance of a contract for breach of contract or repudiation of contract, thereby taking the form of express agreement on damages clearly stipulated by an agreed formula during early stages of contract negotiations.

Liquidated damage clauses are highly common in:

1. Construction contracts;
2. Supply Contract or Master Service Contract;
3. Fintech & IT Service Contracts including 'SaaS' (Software as a Service) Contract;
4. Outsourcing Agreement including Employment Agreement. 

It is also important to distinguish between liquidated damages clause and compensation clauses which can take many different forms in major service agreements.

Compensation Clauses that are NOT Liquidated Damages

Rebate

Liquidated damages clause is also different to 'rebate clause' or 'service level rebate clause' in case of a major failure to provide agreed services within a particular timeframe. Parties to the contract must expressly agree to compensate in other ways such as 'rebate in percentage' for service level (SL) failures rather than relying on formula for agreed liquidated sum. 

Termination for Convenience

Any express right to terminate (e.g., Termination for Convenience clause in Supply Contract) is different to liquidated damage clause although there may be a genuine pre-estimate of loss (e.g., compensation amount for demobilisation or demobilisation fees) incorporated in the contract, if one party exercises its contractual rights to terminate for commercial convenience after the service or supply project has started.

Indemnity, Limit of Liability and Unlimited Liability (No Limitation)

Commercial contracts such as Supply Agreement or Master Service Agreement provide protection against public/product/professional liabilities as a form of indemnity to non-breaching party for any loss suffered as a result of the liability caused by the breaching party.  Indemnity clauses are drafted in a way that is consistent with the insurance policy coverage and may even limit the indemnifying amount up to a particular threshold to avoid 'unlimited liabilities'. The amount of indemnity is payable after breach of contract has occurred as a particular sum by way of compensation to the non-breaching party. 

Indemnity clauses in Master Service Agreement (MSA) may also provide 'unlimited liability' for personal injury, sickness and/or death scenarios, if both parties expressly agree to such indemnifying options under the relevant State and Territory legislations. 

Liquidated Damages vs. Penalties

To be enforceable, liquidated damages must represent a genuine pre-estimate of the likely loss suffered due to the breach. If the amount is excessive or punitive or extravagant, it may be deemed a penalty, which courts will not enforce.

The leading Australian case on this issue is Andrews v Australia and New Zealand Banking Group Ltd  (2012) 247 CLR 205, where the High Court reaffirmed that penalties are unenforceable if they impose an excessive burden rather than a reasonable compensation for a breach.

In commercial contracts liquidated damages clauses are commonly challenged where:

• The amount is disproportionately high or punitive in nature.
• There was no real attempt to calculate a genuine estimate of loss (i.e., no formula or unclear wordings about loss or damage).
• The contract terms create an unfair advantage for one party especially if the proposed sum is extravagant and unconscionable.
• The contract terms did not take into account any reasonable opportunity of the other party to mitigate the situation or rectify contractual obligations.
• any express right to terminate (i.e. Termination for Convenience clause) is triggered although there may be a genuine pre-estimate of loss clause incorporated in the contract as a form of agreed compensation for one party's loss of capital expenditure.

Drafting an Enforceable Liquidated Damages Clause

To ensure your liquidated damages clause is valid and enforceable, consider the following:

1. Genuine Pre-Estimate of Loss – Calculate an amount that reflects the likely financial loss from a delay. Keep records of how the amount was determined. The amount can be determined by the formulae in the context of standard commercial contracts.
2. Clarity – Clearly define the breach that will trigger liquidated damages and the percentage rate to be applied for each day of delay (e.g., $5,000 per day of delay).
3. Cap on Damages – Consider including a maximum liability cap on damages to prevent excessive claims; or apply reasonable and applicable daily rate of liquidated damages to recover loss.
4. Avoiding Penalties – Ensure the clause is not excessive and reflects commercial reality, avoiding any indication that it is meant to punish the breaching party. Contract negotiation in the early stage of a deal is crucial to avoid any penalty clauses.
5. Contract Negotiation & Documentation – If a dispute arises, evidence that both parties negotiated the clause in good faith and understood its basis can strengthen its enforceability and the intention of the parties.

What Happens If There's a Contract Dispute?

If a party challenges a liquidated damages clause, courts will assess whether it is a genuine pre-estimate of loss or an unenforceable penalty. The burden of proof often lies with the party alleging that the clause is a penalty.

In a contract dispute regarding liquidated damages, legal advice is essential to assess:

• Whether the clause is likely to be enforced as general damages or not.
• Whether the provision is penal or not.
• The actual monetary losses suffered due to the breach.
• The best legal strategy for enforcing or defending against a liquidated damages claim if project milestones or service levels are not met within a particular timeframe.
• The best strategy for contract negotiation if one party requests liquidated damages clause in the contract.

Get Expert Advice on Liquidated Damages 

Well-drafted liquidated damages clauses provide certainty and protection in commercial contracts, but they must be carefully structured to avoid the risk of being struck down as penalties. Whether you are negotiating a contract or facing a dispute, seeking legal advice from experienced  contract lawyers early is critical.

At  PCL Lawyers, we assist clients across NSW and Australia-wide with  contract disputes negotiations, and liquidated damages claims and drafting enforceable agreements. Contact us today to ensure your contracts protect your business interests and comply with legal requirements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.