Liquidated damages — a two-edged sword

August 11, 2010

Delay can cause incalculable damages to an owner on a construction project. Such damages, however, may be very difficult to quantify with reasonable accuracy. Thus, in order to help avoid the uncertainty and expense of long evidentiary battles to establish (or refute) the owner's actual damages, parties to a construction contract may agree in advance to liquidate those damages. A "liquidated damages" clause is a negotiated clause to establish in advance a reasonable estimate of the damages that would be incurred by reason of a breach of contract or unexcused delays.

Owner's risks

While there are perceived advantages to the simplicity and certainty of a prior agreement to liquidate an owner's damages, there are disadvantages to the owner. Sometimes liquidated damages may actually leave the owner in a less favorable position.

Low ceiling

As a general rule, an owner may not recover both liquidated damages plus its actual damages. Thus, if at the end of a job the owner is in a situation where it had substantial actual damages which are capable of reasonable determination that are in excess of the amount of liquidated damages, it may find that it outsmarted itself by insisting upon a liquidated damages clause. However, where it is clear that liquidated damages are intended to cover only damages related to a contractor's delay in completion, the owner is not necessarily precluded from recovering additional damages for the contractor's defective work. Similarly, if a contract or statute permits recovery of attorney's fees, then a liquidated damages clause should not prevent recovery of those costs as well.

Unenforceable clause

In order to be enforceable, a liquidated damages clause must meet a three-pronged test. First, the amount set forth in the contract must be a reasonable forecast of the damages sustained as a result of the delay. Second, the harm must be of the type that is difficult or impossible to accurately ascertain. Third, the clause cannot be construed as a penalty.

If the amount set forth in the liquidated damages clause is unreasonably large, liquidated damages will probably be held unenforceable on public policy grounds as a penalty.

Concurrent delay

Generally speaking, a liquidated damages clause will not be enforced if there are concurrent delays. In other words, if the owner and the general contractor are each guilty of delaying the project, the general contractor will probably not have to be straddled with liquidated damages.

Lessons learned

In drafting a liquidated damages clause, there are several key issues to bear in mind.

In order to establish that the a-mount set is a "reasonable forecast" at the time the contract was entered into, work papers and other documents showing how the amount was calculated should be maintained. Arbitrarily assigning a number based solely on the size of the contract is risky.

The clause should be explicit that it is not a penalty. It should recite that the liquidated damages are agreed to because actual damages would be difficult or impossible to ascertain and that the specified amount is a negotiated forecast of anticipated damages, rather than the imposition of a penalty.

If the contract permits the contractor to recover an incentive bonus for early completion, the liquidated damages should not be characterized as a "disincentive" for fear that the amount will be deemed to be a penalty.

The owner should reserve the right to withhold liquidated damages from any payment due, including retainage.

All things must come to an end. Thus, the clause should specify whether the liquidated damages terminate upon substantial completion or final completion. In the absence of such agreement, the damages will probably end upon substantial completion.

Further, the clause is less suspect if it was truly negotiated between relatively equal commercial enterprises. In contrast, clauses between parties of vastly different bargaining strengths may be subject to attack.

         
 

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