The majority of construction contracts for commercial developments will include a provision for liquidated and ascertained damages (LADs). LADs clauses are commercially significant for both the employer and the contractor. An employer knows what he is entitled to should there be a delay in completion of the works and for many contractors, LADs set out a contractual limitation on liability – the inclusion of a provision can benefit both parties. In addition, by specifying the level of damages to be awarded, the employer avoids the laborious and time-consuming process if there is delay of analysing their actual loss.

Given the importance to both parties, it is not surprising that a body of caselaw has developed in relation to LADs. The key issue here is whether the LADs clause is a penalty or a genuine pre-estimate of loss – the traditional view being if it is the former it may not be enforceable. However, the recent English High Court case of Azimut-Benetti Spa (Benetti Division) v Healey [2010] EWHC2234 (Comm) indicates this may not always be the test adopted by the courts.

LADs and penalty clauses distinguished

In construction contracts and development agreements the most common form of LADs provide that if the project is not completed on time, an agreed level of damages may be payable. However, there are other instances when LADs may be due such as when a contractor fails to meet a target area. The traditional view has been that in order to be enforceable, the level of LADs (normally set by reference to a weekly or monthly rate) must represent a genuine pre-estimate of the other party's loss.

By contrast, if the main purpose of a clause is to deter a party from breach (by specifying a level of damages that is disproportionate to the loss suffered rather than a pre-estimate of such losses) such a clause is treated by the courts as a penalty, and is not enforceable. The leading case (Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79) in relation to distinguishing an enforceable LADs clause from a penalty has been applied for nearly 100 years. The case set out various guidelines including the following:

  • the rate of LADs is to be assessed at the time the contract is made and not at the time of the breach (i.e. the party receiving LADs does not need to actually suffer the loss – for example, if the building contract relates to a retail park and the LADs were estimated on the assumption that the retail park was fully let and at the time of the claim for damages this was not the case, the employer would still be entitled to the level of LADs in the contract);
  • a sum which is extravagant and unconscionable in comparison with the greatest loss that could have occurred is a penalty;
  • if it is difficult or impossible to estimate the loss at the time of the contract, this does not prevent the court from deeming it to be a genuine pre-estimate.

The courts will, wherever possible, uphold the contractual terms which fix the level of LADs, especially in commercial contracts which parties of similar experience have freely entered into. Indeed, it is hard to find a case in which the court will strike down a LADs clause in these circumstances.

How do you assess the level of LADs?

An assessment should be made to estimate the level of losses that would be incurred should there be a breach of the contract, with the result that LADs would become due. Depending on the type of project, this may entail: loss of rent; funder charges; alternative accommodation charges; and inflation (amongst others). Whilst such information may be readily available in relation to commercial developments, it may be harder to carry out such an assessment for non-profit developments such as libraries or churches.

It is important to note that there is no "second bite at the cherry" if the losses subsequently incurred exceed the level of LADs specified in the contract. It is therefore worthwhile to spend time considering the various losses that may be incurred and to create an audit trail showing how the level of LADs was arrived at.

A departure from the recognised approach to LADs

The High Court case of Azimut-Benetti Spa (Benetti Division) v Healey has departed from the well established guidelines set out above, and suggests that some clauses may fall between the LADs/penalty clause distinction. The claimant was an Italian yacht builder who entered into a contract with the defendant's company for the construction and sale of a yacht. The contract contained a provision that on lawful termination of the contract by the claimant, it could recover 20% of the contract price as compensation for its estimated losses. The defendant's company failed to pay the first instalment, and so the claimant terminated the contract and applied to the courts to recover 20% of the contract price from the defendant.

The defendant argued that the clause was a penalty and consequently that he had no liability. The court disagreed and stated that the clause was "not even arguably a penalty" and was enforceable. The judge did not however apply the above guidelines in order to reach his decision. Instead, Justice Blair reasoned that the LADs clause as a whole was "commercially justifiable." He explained that the terms of the contract, including the LADs clause, had been freely entered into and that both parties had had the benefit of expert representation whilst the contract was being negotiated. Justice Blair emphasised that in a commercial contract of this type, the court should normally uphold what the parties had agreed. Importantly, the court rejected the defendant's argument that it had to form a view of the claimant's maximum possible loss and did not attempt to ascertain whether the level of LADs was a genuine pre-estimate of the claimant's loss. Implications of the "third way"

This case could be significant for LADs clauses, as the decision indicates an increasing reluctance on the part of the courts to overturn provisions negotiated and agreed by commercial entities. Nevertheless, best practice would dictate that LADs should be based on genuine pre-estimates of loss and an audit trail of how these figures were arrived at should be maintained.

In conclusion, parties can be slightly more relaxed about overstating the position when estimating these sums, and should also be aware of the danger of understating the level of LADs, for example in limiting the contractual provision to an amount which may not provide cover for all the losses that may be incurred.

To view the judgement in the case of Azimut-Benetti Spa v Healey click here