PileDriver Magazine Legal: Managing Risk

Managing Risk:  Liquidated Damage Clauses For Delay In Construction Contracts

By Tiffany Harrod, Attorney at Munsch Hardt Kopf & Harr P.C., Houston, Texas
Chair-Elect, the Construction Law Section of the Houston Bar Association and
Carrie Schadle, Senior Attorney at Munsch Hardt Kopf & Harr P.C., Houston, Texas

             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 delay, there can be real financial consequences for contractors.  Courts have long allowed parties to apportion contractual risks as they see fit, especially in the commercial context where the parties are usually considered to be sophisticated, even if their bargaining power is not always equal.  Liquidated damage provisions, such as those found for delay in construction contracts, are common, but must be crafted in such a way as to be enforceable and not against public policy.
Liquidated damage clauses in construction contracts are a common way for the parties to deal with the possibility of delay in the completion of a project and associated potential losses flowing from the delay.[1]  In their most basic form, the party in breach, which is most often the contractor, is obligated to pay the non-breaching party, usually the project owner, some fixed sum of money per set time period  that has been agreed upon in advance and memorialized in the contract.  (It is, after all, no secret that these provisions are meant to protect the owner.)  The non-breaching party is then compensated for losses associated with the delay without the time and expense of having to prove what the actual damages were, in either a civil suit or an arbitration proceeding.  This option is particularly attractive to project owners, because the money can simply be withheld from money 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 that it is enforceable in the relevant jurisdiction if a dispute about payment of the liquidated damages should arise.  Disputes regarding liquidated damages generally arise when the breaching party argues that the provision is not enforceable, in which case courts will generally consider several factors in deciding on enforceability:  the difficulty in measuring the kind of losses an owner suffers because of 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, when entering into a contract that contains a liquidated damages clause, a contractor should presume that it is going to be enforceable.
Liquidated Damages Must Measure Losses That Are Difficult To Prove
Liquidated damages only apply to the exact type of breach specified in the contract.  In its most common form, a provision providing liquidated damages for delay is an agreed upon substitute for actual damages an owner might suffer but that could be extremely difficult, and probably expensive, to prove in court.  These can include many types of damages such as lost financing cost, missed opportunities, or lost rent. 
While very real, these types of damages can be difficult to quantify because questions such as what revenues were lost, the time period during which revenues were lost, and extra costs incurred or costs avoided will have to be answered.  Agreeing to liquidated damages relieves the owner from being able to prove these types of damages, and may also allow a contractor to factor the cost of the contract completion date into its bid.
In some states, liquidated damages provisions may not be enforceable after substantial completion where the owner has been able to occupy and use the project before the final completion date, as 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 could be struck down by a court as against public policy.  In short, they should reflect a loss that is based on what an owner would lose if the project could not be used as intended by the time promised.  This prevents liquidated damages from being seen as a 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, and cannot be merely an arbitrary number chosen by the owner that it thinks is big enough to ensure that the job gets done in 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, an amount of liquidated damages that was properly established courts will still find the damages reasonable because they were based on foreseeable actual damages.
Negotiating Liquidated Damage Provisions
While it is the party challenging the validity of the liquidated damage provision, usually the contractor, 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 rate for liquidated damages.  This is especially true if the liquidated damages are capped.
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 past the completion date, additional management or overhead costs, upstream liquidated damages clauses, 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, and 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 things not in the contractor's control such as delays caused by the owner or weather events.  This is why it is important to document delays and provide notice to the owner when they are not caused by the contractor.
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.

 
[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 would apply as those discussed here related to delay.

Post a comment (* required field)

Name *
Email * (will not be published)
Website
Comments *