Put simply, Liquidated Damages (“LDs”) are a contractual mechanism to ascertain a pre-agreed sum of money as compensation to the client for a breach. LDs are commonly employed in oil & gas contracts, to deal with failure to meet a specified delivery date.
Pros and Cons for a contractor:
- PRO - Certainty
LDs give certainty as to the amount for which you will be liable to your client for the breach. Without them you will be liable for all direct losses incurred by your client resulting from your delay - unless you have negotiated an overall contractual limit of liability for default. Typically contractual caps can be up to 100% or more of the contract price, whereas LDs are often set at about 10% of the contract price.
- PRO - No further financial liability
For a continuing delay after the LDs have been used up the client is likely to have the contractual right to terminate the contract. The LDs clause should apply in that event, ensuring you have no further financial liability to the client.
- PRO - Sub-contractor Liability
If your delivery obligations are dependent on your sub-contractors then you should seek to impose similar LDs in your sub-contracts. This has the dual benefit of (i) off-setting the liability you incur to your client, and (ii) should ensure your subcontractor will be focused on meeting its obligations to you and thereby mitigating your risk.
- PRO - Limits liability
Despite the contract language setting out that LDs are a “genuine pre-estimate of losses” the reality is that for many contracts that will not be true. The client may suffer much greater financial losses as a result of your delay. As an example, if your delay is holding up progress on a project and your client has many other contractors on stand-by whilst waiting for your equipment to arrive, your client will still be paying those contractors on stand-by whilst awaiting delivery from you. Financially, it doesn’t bear thinking about - especially on an offshore project if some of those contractors have vessels or drilling rigs employed.
- PRO - Avoids litigation
Pre-agreeing damages and their application avoids costly and time-consuming litigation to establish liability and the amount of damages.
- CON - Liability without fault
If you have agreed LDs but your delay does not cause any loss to the client (i.e. its project has been delayed through no fault of yours) you will not be relieved of your obligation to pay those LDs (unless that is expressly addressed in the LDs clause, which is unlikely).
How to apply LDs?
Consider including LDs in your contracts if you have key delivery dates which could be compromised. When setting LDs, ascertain what is financially acceptable to you based on:
1. contract value;
2. your ability to meet delivery dates; and
3. your risk appetite.
Lastly it is important to get the LDs clause drafting correct to ensure it protects you in the way intended. It needs to specify that LDs are a “genuine pre-estimate of the loss which will be suffered” and not a penalty (i.e. under English law penalty clauses are not always enforceable). The clause should state that the LDs represent the sole financial liability of the contractor for delay irrespective of negligence or breach - thereby ensuring the arrangement can’t be undermined by the client seeking to recover its losses (beyond the LDs amount) by suing for those at law.
In many cases we would advise that appropriate LDs are a good thing for a contractor. Remember, any financial liability you have under a contract for delivery breach is unlikely to be insured so that will hit your bottom line!