This article was written for the ConsensusDocs newsletter and first appeared here.

With the on-going shortage of construction workers in the industry and other factors ranging from weather to procurement problems, the threat of project delay is real. When a contract contains a liquidated damages clause for assessing project delays, real financial consequences for contractors can result. Courts have long allowed parties to apportion contractual risks as they deem appropriate especially in the commercial context where the parties are considered to be sophisticated even if their bargaining power is not equal.  Liquidated damage provisions such as those for delay that are found in construction contracts are not unusual but they must be crafted in such a way as to be enforceable and not violate public policy.

A liquidated damage clause in a construction contract is a customary way for the parties to deal with the possibility of delay in the completion of a project and the potential losses flowing from the delay.^[1]  In their most basic form, the party in breach, which is more often than not the contractor, is obligated to pay the non-breaching party, usually the project owner, some fixed sum of money for the period that exceeds the designated completion date that was agreed upon in advance and memorialized in the contract.  (It is after all no secret that these provisions are primarily for the owner’s benefit.)  The non-breaching party is then compensated for losses associated with the delay without the time and expense of having to prove in either a civil suit or an arbitration proceeding what the actual damages are.  This option is particularly attractive to project owners because the liquidated damages assessment can simply be withheld from payments owed to the contractor once the agreed-upon completion date has been passed.

However, like any provision in a contract, a liquidated damages provision should be the product of negotiation to ensure not only that it is fair to both parties, but also that it is enforceable in the relevant jurisdiction in the event a dispute arises about entitlement.  The most predictable dispute occurs when the breaching party alleges that the provision is unenforceable, in which case courts will generally consider several factors in deciding the question of enforceability. These include the difficulty in measuring the type of losses an owner incurs due to the delay and the reasonableness of the amount of damages in relation to the anticipated or actual damages suffered.  Despite the possibility of a provision being found unenforceable, contractors should always presume that the clause will be enforced.

Liquidated Damages Must Measure Losses That Are Difficult to Prove

Liquidated damages apply only to the exact type of breach specified in the contract.  In its most common form, a provision providing for liquidated damages for delay is an agreed upon substitute for the actual damages an owner may incur because the actual damages could be extremely difficult and costly to prove in court or before an arbitrator.  These actual damages can include many different types of costs such as additional financing costs, missed opportunities or lost rent. These types of damages are often difficult to quantify because it is always questionable whether the claimed lost revenues are in fact real, and, if so, what is the relevant time period to examine, and whether the extra costs incurred could have been avoided.  Agreeing to liquidated damages relieves the owner from the requirement to prove these types of damages. Agreeing to them also may allow a contractor to factor the cost of a potential late completion date into its bid.

In some states, liquidated damages provisions may not be enforceable after substantial completion when the owner is able to occupy and use the project before the final completion date, because after this time-period damages are no longer difficult to calculate.

Liquidated Damage Must Be Reasonable in Proportion to Anticipated or Actual Harm

If the liquidated damages do not reflect a reasonable estimate of the loss incurred due to delay, they may be deemed an unenforceable penalty and a court could disallow their recovery as against public policy.  Consequently, they should reflect the cost of what an owner would lose if the project could not be used as intended in the time that was agreed to.  This prevents liquidated damages from being regarded as a penalty or punishment.  Whatever the amount agreed upon, in the end it must have been considered reasonable at the time of contracting or bear some relation to the actual loss; it cannot be an arbitrary number that the owner randomly chooses because they think it is large enough to ensure that the job gets done on time.  In other words, the rate must somehow be related to the contract and not be designed to spur performance.  The downside to this for the contractor is that even if the owner incurs only nominal administrative charges because of a delay, the dollar value assigned to a properly established liquidated damages provision will be enforced by the courts as long as they were based on reasonably foreseeable actual damages.

Negotiating Liquidated Damage Provisions

While it is the party, usually the contractor, challenging the validity of the liquidated damage provision that has the burden of proving that the provision is unenforceable, if a court were to find a liquidated damage provision unenforceable the owner would then be in the position of having to prove its actual damages.  For this reason, it is in both parties’ best interests to craft a fair and enforceable liquidated damages provision.  So even though these provisions are primarily designed to protect owners, contractors should remember that a liquidated damage provision also prevents them from being exposed to lengthy and expensive court battles and actual damages, which could easily exceed the agreed-upon amount of liquidated damages.  With liquidated damages at least a contractor will know what its exposure is and can take that into account when negotiating the daily rate for liquidated damages.  This is especially true if the liquidated damages are capped at a maximum amount.

Parties should consider and try to factor in all potential costs that may be incurred if a project is delayed so that if a dispute arises the amount will be considered reasonable.  This might include financing costs incurred past the completion date, additional management or overhead costs, upstream liquidated damages clauses,[2] or pre-scheduled uses to which the project has already been committed.  Parties may also agree to place a cap on the amount of the liquidated damages, whether it is a sum certain or a percentage of the final contract price or the contractor’s fee.

Another important factor to consider is how the liquidated damages provision will be triggered.  This includes a consideration of whether it will be based on substantial completion, important milestone dates, a date certain, or a certain number of days from a notice to proceed, as well as the impact of schedule adjustments requested either by the owner or the contractor.  It is important defense for a contractor to ensure that there is a workable mechanism for contract deadlines to be extended when delays are caused by factors not in the contractor’s control such as owner-caused delays or weather events.  Therefore, it is important to document delays and provide notice to the owner when they are not the contractor’s responsibility.

Lastly, in some states, the liquidated damages specified for a particular breach will be the exclusive remedy available for that breach.  This means that if the breach for some reason caused actual damages greater than those provided by the liquidated damages provision, the non-breaching party’s damages will still be limited to the amount agreed to in the contract for the liquidated damages.  In those states where this is not the automatic rule, a contractor may want to keep this in mind and specify in the contract that the liquidated damages are the exclusive remedy for a project delay.

Flow-Down Liquidated Damage Provisions

General contractors usually try to pass some of the liability for project delays to their subcontractors.  When acting as a subcontractor it is important to pay attention to liquidated damage provisions in the prime contract that may be incorporated by reference and flow down into the subcontract, as they may be assessed at a higher rate than those the subcontractor has agreed to.  Generally, for damages to be assessed under these provisions, the subcontractor must have been responsible for the delays, and may not be the result of either other subcontractors or the general contractor.  And to collect the flow-down liquidated damages, the owner must have actually assessed liquidated damages to the general contractor.  A subcontractor should make sure that it is responsible only for those delay damages it causes.

For more information, please contact Tiffany A. Harrod.

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[1] Liquidated damage provisions can be used to compensate a party in the event of other non-performance or breach of contract, and the same principles as those discussed here related to delay would apply.

[2] Upstream liquidated damages clauses refer to clauses contained in an agreement between two parties higher up in the contracting chain.