Consider a liquidated damages clause

Reviewing your contract is one of the most important aspects of any business relationship. If you work in industries such as building, you may have come across a liquidated damages clause. If not, this article from Sprintlaw will help shed some light on its benefits 

Like any other contract, you want to make sure your agreement covers any possibility of non-performance. In other words, what might happen if the job isn’t done as agreed? This is where a liquidated damages clause might come in handy. 

What is a liquidated damages clause? 

Before we delve into the clause itself, it’s important to understand the concept of liquidated damages within the context of New Zealand law. 

In New Zealand, a liquidated damages clause specifies the amount of compensation to be paid if a contract is breached. The key feature here is that the amount is predetermined and agreed upon by both parties at the time the contract is formed, rather than being assessed after a breach has occurred. 

Liquidated damages vs unliquidated damages 

Liquidated damages are distinct from unliquidated damages, which are not fixed in advance and are determined by a court after a breach has occurred, based on the actual loss suffered. 

When would you need a liquidated damages clause? 

In industries such as landscaping, where timely completion is critical, a liquidated damages clause can be particularly useful. It sets out a fixed sum that the contractor must pay to the principal if the project is not completed on time, thus limiting potential disputes regarding compensation for delays. 

Example 

KiwiBuild has engaged a landscaping contractor, Billie, for a significant project. The contract stipulates that Billie must complete the work within two months. If Billie fails to complete the work on time, she is required to pay $2,500 for each week the project remains incomplete, as per the liquidated damages clause in their agreement. 

Therefore, if Billie finishes the work two weeks late, she will owe KiwiBuild $5,000 in liquidated damages. 

What does it include? 

A liquidated damages clause in New Zealand should be tailored to the specific business relationship, but typically includes: 

• Practical completion – the clause should define or include a test to determine whether the work is sufficiently complete to be used for its intended purpose. 

• Date for practical completion. 

• Test for breach – at what point is it considered a breach of contract requiring the payment of damages? 

Exceptions for unforeseeable delays 

While a liquidated damages clause is designed to provide certainty, there are circumstances where delays should not automatically trigger liability. For instance: 

1. Unforeseen site conditions: If a builder’s landscaping subcontractor encounters an unexpected rock during excavation – causing a two-week delay – it may be argued that this delay is outside the contractor’s control. 
2. Force majeure events: Natural events or other unanticipated circumstances that disrupt work should be clearly excluded from triggering liquidated damages. 

Practical tips for unforeseeable delays 

1. Define exceptions: When drafting your clause, include specific language that outlines events or conditions (such as natural obstructions, extreme weather, or other unforeseen site conditions) where the liquidated damages clause would not apply. 
2. Review regularly: Ensure that your clause is reviewed and updated regularly to reflect current industry standards and the unique risks of your project. 

How are damages calculated? 

The amount of liquidated damages should reflect the potential costs and losses to the principal, including: 

• Insurance costs. 

• Administrative expenses. 

• Staffing costs. 

• Losses resulting from project delays. 

It’s crucial to ensure that the clause is not deemed a penalty, which is unenforceable under New Zealand law. A lawyer can help draft a clause that is likely to be upheld by the courts. 

Pros and cons of liquidated damages 

A liquidated damages clause provides an incentive for the contractor to complete the work on time and sets clear expectations for compensation in case of delay. It can also prevent the need for dispute resolution processes, saving time and preserving business relationships. 

However, if the sum specified is disproportionate to the actual loss suffered, it may be considered a penalty and thus unenforceable. 

How do you enforce a liquidated damages clause? 

In New Zealand, the enforceability of a liquidated damages clause depends on whether the sum represents a genuine pre-estimate of loss. If it is deemed to be a penalty, the courts will not enforce it. 

What are penalties? 

A penalty is a sum that is not a genuine pre-estimate of loss and is disproportionate to the harm caused by the breach. New Zealand courts will not enforce penalty clauses. 

Next steps 

If you’re in an industry where a liquidated damages clause is beneficial, it’s important to have it drafted properly.  

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If you need help sorting out the legal side of things as a sole trader, Sprintlaw is always ready to help you out. We offer a whole range of services to help you start and grow your business. You can contact our team on 0800 002 184 or team@sprintlaw.co.nz for a free, no-obligation chat.