Liquidated Damages Explained – How to Calculate Them

Financial compensation may not be the Employers desired solution when a Contractor is late in completing their obligations to complete the Works under a construction contract, as delivery on time may be the priority. All Employers expect their projects to be constructed on time and according to their design which means that a financial remedy is not going to satisfy in the same manner as a completed project would have done. When things do go wrong or when something is not operating properly, or is delayed, a solution is what the Employer seeks. Despite of this, general damages (also known as un-liquidated damages) are one of the most important remedies for a breach of any contract, but these require that firstly, the non-defaulting party proves that it has incurred actual loss as a result of the breach and secondly that the loss must is not judged to be too remote. A Liquidated and Ascertained Damages clause attempts to avoid these two legal requirements leaving the Employer to prove that a breach has occurred and unless otherwise challenged the calculation of Liquidated and Ascertained Damages is based on a fair estimate of the costs resulting from the non-performance of the Contractor.

All standard forms of construction contract commonly used in Malaysia generally include a clause which entitles the Employer to a specified level of damages, referred to as “Liquidated and Ascertained Damages” if the Contractor is late in completing the Works. Liquidated and Ascertained damages hereafter called LAD’s as stated above in effect offer the advantage to the Employer of attempting to replace the their common law right to recover damages for late completion by including a contractual right to a pre-determined sum for the period of delay. For the Contractor it offers the advantage of allowing him to fix his tender price with more certainty, since he can price the level of risk associated with the stated LADs into his tender amount. It also allows the Contractor to later make commercial decisions in respect of accelerating by expending on additional resources or hand over the project late and incur LAD’s if the project is running behind schedule. Finally, the level of LAD’s specified in a contract acts as a ceiling for the amount of damages payable to the Employer.

LAD provisions contained in construction contracts are usually expressed as a certain sum payable for each day, or week or part of week by which practical completion is delayed.  Other types are a straight lump sum, a fixed percentage of the contract sum or a maximum rate which reduces as part or parts of the project become available for occupation and use.

It has long been the case under common law systems that if a clause for LADs has been included as a penalty for late completion, rather than a genuine pre-estimate of loss, then the courts will not enforce it.  However, just because the level of LADs specified in a contract is substantially higher than the loss actually suffered did not necessarily make the LADs clause invalid as a penalty.

The courts outside of Malaysia generally do not require that the level of LADs payable should equate to the actual loss suffered by the Employer merely that the figure in the contract is a genuine pre-estimate of loss at the time the parties entered into the Contract. The Courts have decided that even in the event that circumstances changed in between the date of the Contract and the entitlement to LADs arising, so that the loss suffered by the Employer is significantly less than the LADs provided for in the Contract.

In Malaysia, there is no distinction between liquidated damages and penalties as understood under common law elsewhere, in view of Section 75 of the Contracts Act 1950 which provides that in every case the court must determine what is reasonable compensation, whether or not actual damage or loss is proved to have been caused. Thus in Malaysia where an Employer is claiming for actual damages in an action for breach of contract he must still prove the actual damages and any failure to prove such damages will result in the refusal of the court to award such damages. For cases where the court finds it difficult to assess damages for the actual damage as there is no known measure of damages employable, and yet the evidence clearly shows some real loss inherently which is not too remote, the court ought to award substantial damages as opposed to nominal damages which are reasonable and fair according to the court’s good sense and fair play. In any event, the damages awarded must not exceed the sum so named in the contractual provision.

Interestingly under the PAM 2004 Standard Form of Building Contract a specific clause was added to the contract which attempted to exempt the Employer from having to prove their actual loss and exclude the intervention of the court in determining a reasonable compensation under Section 75 of the Contracts Act. However in view of the Johor Coastal decision (Johor Coastal Development Sdn Bhd v. Constrajaya Sdn. Bhd. [2009]); any provision to circumvent the need to prove actual loss will be redundant and meaningless.

Outside of Malaysia where common law prevails the courts have always been wary of contractual LAD provisions and attempt to ensure that the clauses are interpreted against the party seeking to rely on them.  Hence there are still lots of cases involving contractors trying to avoid being caught by such clauses by arguing that the LAD amounts are in effect a penalty and are, therefore, unenforceable.  However, while the courts interpret such clauses strictly, and ensure that the party seeking to enforce them have complied with them to the letter, the courts generally will not interfere unless the clause is judged to oppressive.  Where two parties have freely entered into a contract, the courts are reluctant to step in unless the contract is in some way unconscionable.

It should be remembered that even if a court decides that the LADs clause is unenforceable, this does not mean that the Employer is then precluded from claiming damages from the Contractor for delay.  The Employer would merely have to rely on his common law right to damages for breach of contract but as stated earlier this amount should not exceed the amount if any stated in the Contract.

Indeed some Employer may prefer to rely on their common law right to recover actual damages rather than risk being limited in the recovery of damages by the inclusion of a pre-estimate of damages which proves to be less than their actual damages thus preventing them from recovery of their actual damages. In such cases the Employer may consider omitting the LAD clause completely and state that general damages for breach will apply. Where the Employer simply just deletes the LAD clause and the Contractor fails to complete the Works on time, the Employer may pursue a claim for damages under the normal operation of the law and only clear express words in the Contract may rebut this presumption. But where the parties agree to omit the LAD clause for example during the course of contract negotiations the court may view that this is agreement between the parties that the parties have agreed that no damages apply for delays in completion of the Works by the Contractor. Thus it is important that the Employers intention to recover general damages in the case of delay in recorded in any negotiations between the parties.

Employers will lose their right to damages for delays if the LAD clause states “nil”. In the case of Temloc Ltd v Errill Properties Ltd [1987] the court took the view that where under the LAD clause the amount was stated to be “nil” that on the proper construction of the contract the parties had agreed that no damages would be payable by the Contractor in the event of failure to complete the work on time.

So now that we have considered the implications of the LAD clauses in contracts under the common law system and specifically in Malaysia it is clearly important that the amount stated as being the amount of LAD for delays in completion represents a fair estimate of the likely damages that the Employer will incur. Indeed if the amounts are considered fair and reasonable then there is a reduced chance that a Contractor will opt to challenge the deduction of these amounts by the Employer in the event of Contractor delays. This will offer the Employer the advantage in Malaysia of possibly not having to go to the expense of having to prove his damages in the courts. Under the common law system elsewhere it will limit the opportunity of a contractor challenging the LAD’s on the basis of them being a penalty.

It is therefore recommended that liquidated damages are thoroughly considered by the Employer and the quantity surveyor and a detailed record of their calculation is retained in case they are challenged at a later date. Care should also be taken when calculating the damages applicable to each section, where sectional completion is anticipated or included within the Contract.

Once the Employer has decided to include a liquidated damages clause, he must then consider the type of damages he is likely to want to recover and the calculation method to adopt. Typically the Employer must consider the following likely damages which result from delay:

A)  Direct Costs incurred under the Contract

B)  Lost Revenue and Profit

C)  Additional Project Administration Costs

D)  Damages and Penalties to which they may be liable

E)   Interest and Financing Costs

F)   Cost Implications to third-party contracts

G)  Losses for Tax or Investment Incentives

There are a considerable number of acceptable methods and techniques that may be adopted to calculate a genuine estimate of the likely damages for each type of damage at the time of contract formation.

Below is a sample Calculation for Liquidated Damages provided for guidance only as it is essential the consideration in relation to the circumstances surround the specific project is made in any calculation of likely damages.

A) Direct Costs

The Calculation of direct cost will depend upon the type of project and the use the Employer is going to put the project to. For calculation of direct costs we have used the construction of a new office building as an example which is being built to relocate the Employer Head Office Operations.

Description Cost Per Month (RM) Cost Per Day (RM)
Rental of Office

800,000.00

26,667.00

Total

26,667.00

B) Lost Revenue & Profit

The Calculation of lost Revenue & Profit will depend upon the type of project and the use the Employer is going to put the project to. For calculation of direct costs we have used the construction of a brand new factory for the assembly of Cars. If it were a condominium the Revenue and profit would be gained from sale of the units.

Description Cost Per Day (RM)
Production Rate

100 cars per day

Selling Price

120,000.00 /car

Production Cost

90,000.00/car

On costs
Marketing

3,000.00

Sales

1,500.00

After Sales

1,500.00

Others

700.00

Net Income Per Car

23,300.00

100

2,330,000.00

Total

2,330,000.00

C) Additional Project Administration Costs

The Calculation of Administration cost will tend to be similar on most projects there will be the Employers Internal Costs and the Costs associated with Outside Consultants and Specialists who he engaged to administer the Contract

Internal Costs

Description Monthly Cost (RM) Cost Per Day (RM)
Project Manager

20,000.00

667.00

Personal Assistant

8,000.00

267.00

Clerical Support

5,000.00

167.00

Others

7,000.00

233.00

Total

1,334.00

Consultants & Specialists

Description Monthly Fee (RM) Cost Per Day (RM)
(Post Contract)
Project Manager

35,000.00

1,167.00

Architect

35,000.00

1,167.00

Structural Engineer

28,000.00

933.00

M&E Engineer

30,000.00

1,000.00

ID Architect

20,000.00

667.00

Landscape Architect

20,000.00

667.00

Commissioning

30,000.00

1,000.00

Clerk of Works

15,000.00

500.00

Service Tax

10,650.00

355.00

Consumables

4,000.00

133.00

Total

7,589.00

D) Damages & Penalties

It is common that developers or investors will incur penalties or damages if a development or facility is late being constructed. An example may be a power production facility which has a power take off agreement or is also tied in to minimum purchase of fuel through forward purchase agreements which were required to obtain finance for the project.

Description Penalty Amount Cost Per Day (RM)

(RM)

Damages for none
Supply of Power

45,000.00

45,000.00

None take up of
Fuel

2,500.00

2,500.00

Total

47,500.00

E) Interest & Financing Charges

Construction finance is normally more expensive than the cost of a mortgage thus the costs of fiancé during the construction period due to the risk cost more than a mortgage would cost on the finished building thus if the Employer is financing the construction through a loan this additional cost needs to be allowed for.

Description

Amount

Cost Per Day (RM)

(RM)

Construction Loan

1,200,000.00

Interest (Month)
Mortgage Rate
(Month)

1,000,000.00

Difference

200,000.00

6,667.00

Total

6,667.00

F) Cost Implications to Third Party Contracts

An Employer may need to engage additional contractors directly to either complete works on the Works during or after the Contractor has undertaken his obligation. If a delay causes these third parties to be delayed or incur costs which would be recoverable by the Third Party from the Employer this needs to be reflected in the LAD amount.

For example in a contract to construct a hotel Third Party liabilities as a result of delays could be ID contractors, term maintenance contractors, storage costs for fixtures and fittings suppliers etc.

Description

Amount

Cost Per Day (RM)

(RM)

ID Contractor (Day)

5,000.00

5,000.00

Term Maintenance
Contractor (month)

20,000.00

667.00

Storage costs for
Equipment (month)

8,000.00

267.00

Total

5,934.00

G) Loss of Tax or Investment Incentives

If we use the car production facility as an example. If it a company is granted a special investment license which gives five years VAT purchase or exemption from import duties etc. for a set five-year period this may run from commencement of construction period so as to allow the company to benefit from the exemption for the construction investment as well as the production of goods when operational. Delays in extreme cases could remove this advantage but more likely they would reduce it only. Thus if a company were to make an additional profit due to the incentives of 10% based on income amount then it can be seen that if based on the daily Income generated of RM, 2,330,000.00 the delay in construction would be costing the company RM 233,000.00 per day in lost incentives.

So to summaries each project will have its own applicable resultant damages as a result of delays and it is important that consultants work with Employers to establish these rather than make the mistake of opting for what they perceive as the industry norm or attempting to calculate LADs based on the estimated contract value which may well leave their clients short-changed and them facing negligence claims.

MALCONLAW 2012