Liquidated Damages

Posted on 13 January 2015

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In some of the commercial contract negotiations that I involved, there are lengthy discussion on liquidated damages clause is always contentious between the parties.

What is ‘liquidated damages’?

It is a fixed and contractually agreed sum of money which is payable by the defaulting party, or a genuine pre-estimate of the actual loss that an innocent party will suffer, in the event that a contractual obligation is breached, for instances, when the seller delays in delivery goods, or the buyer delays in making payment.

An example of a liquidated damages clause, “All sums due from either of the parties to the other which are not paid on the due date shall bear interest from day to day at the annual rate of 12%.”

Liquidated damages vs penalty

What if the liquidated damage is grossly disproportionate to the actual loss, i.e. “the interest on late payment is calculated at the daily rate of 1%”? Will the Court (or laws) allow such grossly disproportionate liquidated damages?

In English and Australian jurisdictions, such extravagant and unconscionable liquidated damages clause, is described as ‘penalty’, and it is not legally enforceable.

In Malaysian jurisdiction, liquidated damages clause is subjected to the application of s 75 Contracts Act. The Court has the right to determine what ‘reasonable and fair compensation’ is and disallow the grossly disproportionate liquidated damages.

Challenges during negotiations

Liquidated damages clause is a double-edged sword. It may work in favor, and it may work against; especially where reciprocal is required during the contract negotiation.

For instance, in a contract of sales of goods, the buyer may enforce liquidated damages against the seller if the seller fails to deliver the goods on the agreed date. In return, the seller may enforce liquidated damages against the buyer if the buyer fails to make a payment on time.

Therefore, if I am representing for the seller I would be unable to demand a late payment interest on an annual rate of 24%, while only agree to pay late delivery interest on an annual rate of 8%.

Sometime, there could be a situation where it is difficult to pre-estimate a damage which is too remote. To convince the counterpart to accept my proposed liquidated damages quantification, industrial benchmark or a trade customcould be a good reference.

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Posted in: Contract Law