In the construction industry, delays can be costly. A project running late may mean lost rental income, missed deadlines or extra storage fees. To address these risks, construction contracts often include financial clauses that set out what happens if one party fails to deliver on time.
Two common terms that appear in these agreements are liquidated damages and penalties. At first glance, they may seem similar – both involve a sum of money being paid when something goes wrong. But in law, the difference is significant. One is usually enforceable, while the other may be struck down by the courts.
What are liquidated damages?
Liquidated damages, sometimes referred to as liquidated and ascertained damages (LADs), are pre-agreed sums of money written into a contract. They are triggered if a contractor fails to meet a specific obligation, such as completing work by a set deadline.
In construction, these damages are typically calculated on a daily or weekly basis. For example, a contract might state that the contractor must pay £500 for every week a project is delayed. The figure should represent a reasonable estimate of the losses the employer is likely to suffer, such as rent they cannot collect or extra financing costs.
The main benefit of liquidated damages is certainty. Instead of the employer having to prove their actual losses in court, the parties agree on a figure in advance. This simplifies claims, reduces disputes and provides a clear incentive for the contractor to stay on schedule.
What are penalty clauses?
Penalty clauses, by contrast, are terms that go beyond compensation and are designed to punish the defaulting party. Under English law, these clauses are unenforceable. A clause will generally be considered a penalty if the amount is extravagant or out of proportion compared to the loss that might actually be suffered.
For example, if a contract requires a contractor to pay 20% of the project’s entire value for a one-week delay, the courts are likely to view this as a penalty. The sum does not reflect the employer’s genuine loss but instead operates as a deterrent or punishment.
The distinction between liquidated damages and penalties has been explored in a number of key cases. In the landmark case of Dunlop Pneumatic Tyre Co Ltd v New Garage (1915), the court set out that damages would be considered a penalty if they were “extravagant and unconscionable” in comparison to the greatest loss that could be expected.
How UK courts treat liquidated damages vs penalties
Modern case law has refined the way courts look at these clauses. The Supreme Court’s decision in Cavendish Square Holding BV v Talal El Makdessi (2015) confirmed that a clause will not be struck out simply because the damages are higher than the actual loss suffered. Instead, the question is whether the clause protects a legitimate business interest and whether the amount is proportionate to that interest.
This means that courts are now more willing to uphold liquidated damages provisions, provided there is a clear commercial justification for them. What matters is not the label used in the contract but the substance of the clause. If the figure is clearly punitive or bears no relation to the employer’s likely loss, it risks being categorised as a penalty and ruled unenforceable.
Key drafting tips for enforceability
To ensure liquidated damages clauses are enforceable in construction contracts:
- The figure should represent a genuine pre-estimate of loss at the time of contract formation
- Keep a record of how the figure was calculated – such as projected rental losses or financing costs
- Avoid using damages that are designed purely to punish the contractor
- Be clear that the purpose of the clause is compensation, not deterrence
By showing that the clause was commercially justified, parties improve their chances of the provision being upheld.
Practical examples in construction
Consider a project where late completion means the employer cannot lease a new office space. A clause requiring the contractor to pay £500 per week of delay, reflecting the anticipated rental income, is likely to be enforceable as liquidated damages.
By contrast, a clause that requires the contractor to pay 25% of the total contract value for any missed deadline would almost certainly be treated as a penalty. The sum is disproportionate and does not reflect the employer’s real losses.
Employers should also remember that issues like concurrent delay – where both parties contribute to the delay – may complicate how liquidated damages are applied. Careful drafting and legal advice are essential in these situations.
Protecting your interests in construction
In construction projects, liquidated damages can provide certainty, fairness and an effective way to deal with delays. But penalty clauses are unenforceable and risk undermining the contract altogether. The difference lies in whether the figure reflects a genuine attempt to compensate for likely losses or whether it is an excessive penalty.
Before finalising any contract, it is sensible to review liquidated damages provisions with a solicitor experienced in construction law. Doing so can protect your project from unnecessary disputes and ensure the clause is enforceable if it is ever tested in court.
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