Introduction

Liquidated Damages (LDs), also known as Liquidated and Ascertained Damages (LADs), are clauses that establish a predetermined amount that the breaching party must pay to the other party for a specified breach and operate as an exclusive remedy in respect of that breach. The primary purpose of these clauses is to pre-define the damages payable in the event of a breach, ensuring that the damages are compensatory rather than punitive.

Historical Origins and Development

Penal bonds were commonly used before the introduction of LDs. These bonds involved a promise to pay a specified sum if another obligation was not fulfilled. Initially, common law Courts upheld and enforced these penal bonds – however, Courts of equity intervened, offering relief by restraining actions based solely on penalties.

After the penal bond, the agreed sum for breach of contract emerged, reversing the previous approach where penalties were the primary obligation in agreements. In the 18 ^th Century, a party could choose to sue either for the penalty or for damages.

It was not until 1801 when the doctrine of LDs was first established, pursuant to which a plaintiff could only recover the actual damage proven, even under common law. This implied that if the sum was a pre-estimate of the loss, it would not be regarded as a penalty and could be recovered as LDs.

Difference between LDs and Penalties

The distinction between an LDs clause and a penalty clause in a contract is critical as it affects the enforceability of the stipulated sum in case of breach.

First, a stipulated sum will be classed as a penalty where it is in the nature of a threat fixed in terrorem of (i.e., to scare) the other party, coercing them to act in a particular way with the intention of preventing a breach of the contract. Generally speaking, when a stipulated sum is described as being in terrorem it implies that the amount is not a genuine pre-estimate of loss, but rather a punitive measure which is designed to coerce the other party into fulfilling their obligations under the contract out of fear of the severe penalty.

Secondly, a stipulated sum is considered to be a penalty if it is extravagant and unconscionable in comparison with the loss that could be proven to have followed from the breach. In addition, when a single stipulated sum is applied to various types of breaches – some of which may carry substantial financial consequences, while others are relatively minor – it raises a presumption that the sum is intended as a penalty.

This presumption, though not definitive, suggests that the sum is not a genuine pre-estimate of damages but rather a punitive measure designed to discourage breaches of any kind.

Pros and Cons

In construction contracts, LDs clauses are a critical tool used to manage and allocate risks associated with potential breaches, particularly delays in project completion. While LDs clauses offer significant advantages in terms of certainty and risk management, they also come with potential drawbacks that must be carefully considered during contract negotiation.

Pros

One of the primary benefits of LDs clauses is that they define the contractor’s liability for a specified breach, leaving both parties with certainty on the potential consequences of a breach. It is difficult to predict additional costs within contractual relationships, particularly those related to delays, with the result that establishing fixed monetary liability on the outset offers valuable clarity to both parties. For the contractor, agreeing to LDs provisions reduces uncertainty surrounding potential penalties for missing the completion deadline, allowing for more accurate risk assessment.

In the case of Ravina Agencies Limited v Coast Water Works Development Agency (2024) KEHC 3264 (KLR) the Court examined a contractual provision stating that the payment of LDs would not affect the contractor’s liabilities. The Court observed that: –

“There is no dispute that the Defendant deducted Kshs 4,415,299.88 from the sums due to the Plaintiff for completed works. The deduction is reflected in the Certificate for Interim Payment dated 14th October 2015, at page 88 of the Plaintiff’s Bundle of Documents. The explanation given by DW1 was that the aforesaid sum was deducted as liquidated damages on account of the delay the Plaintiff in completing the works and as pointed out herein above, notice to this effect was given by the Defendant vide its letter date 28th July 2015…

From the uncontroverted evidence presented herein, it took the Plaintiff 1½ years to complete the project. In the premises, the Defendant was within its rights to charge liquidated damages as provided for in Clause 52.1 of the General Conditions of Contract…”

In addition, LDs negate the need for the innocent party to prove actual loss suffered as LDs are recoverable as a debt, thereby bypassing the need for costly proof of damages. The clause enables a contractor to conduct a cost-benefit analysis to assess whether it is more commercially advantageous to pay the stipulated damages or pursue other options. Furthermore, the specified level of LDs serves as a ceiling for damages payable, thereby preventing a party from altering the amount even if the actual loss surpasses the stipulated LDs.

LDs also save time and expenses. By agreeing on a rate for LDs, the need for costly and lengthy legal proceedings to determine the employer’s losses from a breach is eliminated. Instead, the employer can simply deduct the damage from an interim or final payment to the contractor, following the issuance of a “pay less” notice. Although the contractor must pay the LDs, they avoid the legal costs that would otherwise be incurred in proceedings to determine the general damages owed to the employer for the breach.

Further, from a commercial perspective, the employer’s reasons for imposing LDs are likely to include the desire to deter breach of contract or, at least, to encourage compliance by the contractor in the contract.

Cons

Typically, LDs clauses are designed to apply only to specific breaches. However, there are instances where an employer may attempt to impose LDs for a different type of breach. Conversely, though less common, an employer might argue that a particular breach falls outside the scope of the LDs clause, while the contractor contends that it does. For example, if the employer suffers substantial and unforeseen loss, they might seek to bypass the exclusive remedy provided by the LDs clause in favor of pursuing general damages.

One of the primary benefits of LDs clauses is that they define the contractor’s liability for a specified breach, leaving both parties with certainty on the potential consequences of a breach. It is difficult to predict additional costs within contractual relationships, particularly those related to delays, with the result that establishing fixed monetary liability on the outset offers valuable clarity to both parties.

Issues related to LDs in a sub-contract arise from the terms agreed upon during contract negotiations. One challenge is passing down LDs from the main contract to the sub-contract. If the sub-contract stipulates a lower LDs amount than the main contract, the main contractor’s ability to pass on LDs deductions to the responsible sub-contractor is limited to the lesser amount. This exposes the main contractor as it will be forced to cover the shortfall in the LDs deducted by the employer.

Consequently, if a sub-contractor’s delay causes a corresponding delay for the main contractor under the main contract, the amount recovered from the sub-contractor would be borne by the employer. In cases where LDs are the exclusive remedy for delay, the main contractor would receive no additional compensation for direct losses caused by the sub-contractor’s delay beyond the LDs paid to the employer under the main contract.

LDs clauses generally do not allow a party to recover a higher sum than the stipulated amount, even if the actual damages are significantly greater. This situation often arises when the stipulated sum is intended to cover a range of varying and potentially unprecedented breaches. In the case of Diestal v Stephenson (1906) 2 KB 345, a contract for the sale of coal stipulated that the defaulting party would pay one (1) shilling for every tonne not delivered. Despite the seller’s greater loss due to non-delivery, the Court held that the seller was limited to recovering only the stipulated amount.

In an ideal contractual setting, LDs would be negotiated between parties of equal bargaining power ensuring both parties agree on terms that are balanced. This may, however, not be the case in public contracts awarded through tendering processes whereby contracts may be presented on a “take it or leave it” basis with the contracting authority having pre-determined LDs.

Alternative Remedy

An alternative remedy or option to LDs is extension of time, where the employer (normally acting through its designated architect) permits the contractor’s request for an extension of time with respect to the completion deadline as a result of a relevant delay event specified in the contract. These events include but are not limited to force majeure, variations to design, industrial action, abnormal weather conditions, or delays caused by the employer’s failure to hand over the site on time.

Conclusion

LDs clauses serve as a powerful tool in contract management, offering clear benefits in risk allocation, cost certainty, and streamlined dispute resolution. However, they also come with limitations, such as the risk of unenforceability if deemed punitive and the challenge of applying them to unforeseen breaches. Parties must carefully draft LDs clauses to balance fairness with commercial needs, ensuring they are neither excessive nor too restrictive. Ultimately, the decision to include LDs should align with the parties’ overall risk management strategy and project objectives.