Liquidated Damages – The Basics

Liquidated damages provisions are included in many modern private and public construction contracts as a convenient way for owners and contractors to allocate and define their risk in the event of a breach.  Construction industry participants would be well served to have a firm grasp on the fundamentals of such provisions to assist them in negotiating, performing or litigating their next contract.

What are Liquidated Damages?

In general, liquidated damages provisions specify a predetermined amount of money that must be paid as damages if one party fails to meet certain contractual requirements.  In construction contracts, this typically manifests as a fee per unit of time (the “Liquidated Amount”) in the event of a missed schedule milestone such as Substantial Completion.  The Liquidated Amount is usually expressed as dollars per day.  Liquidated damages may also be tied to performance metrics, such as efficiency, output or availability of a project or facility.  For example, there could be a specified fee should a power generating facility fail to produce the contractually specified power output.  They can also require “specific-performance,” such as the forfeiture of a deposit or the performance of a specified act upon a breach.

The ultimate purpose of a liquidated damages provision is to allow the parties to agree, at the outset of their relationship, on a fair and reasonable estimate of damages that might otherwise be difficult or impossible to calculate.  In other words, a liquidated damages provision benefits both parties by defining downside risk, while eliminating the need to spend time and resources calculating actual damages and proving those damages through the (often costly) dispute resolution process.

In the case of liquidated damages for delay, construction contracts typically specify a date by which schedule milestones must be met and set forth requirements for determining when they have been achieved.  Such requirements may include the completion of a specified scope of work, the receipt of necessary permits (such as a certificate of occupancy) or owner sign-off on project closeout documentation (such as a certificate of substantial completion or final application for payment).  Liquidated damages will begin to accrue if a milestone is missed and will continue to accrue until that milestone is met or a contractual cap on liquidated damages is reached.

Liquidated damages provisions related to performance metrics will also usually define in detail the conditions by which performance is measured and/or the period in which liquidated damages for performance can be assessed.  When negotiating a construction contract, industry participants would be wise to make sure contractual milestones, triggering events and all aspects of their liquidated damages provision are as specific as possible for ease of enforcement and to lower the likelihood of a dispute.    

When are Liquidated Damages Provisions Enforceable?

Although freedom of contract is a bedrock principal in American jurisprudence, and contracts executed by sophisticated parties are typically enforced as written, a liquidated damages provision will not be upheld where it constitutes a “penalty.”  At its core, the inquiry into whether a liquidated damages provision constitutes a penalty revolves around whether it was designed to estimate damages in the event of a breach, or to serve as a metaphorical guillotine, hanging over the head of a contractor to compel continued performance.

In evaluating this question, courts put themselves in the shoes of the parties at the time the contract was executed and examine two primary factors:

1.     Whether the loss caused by the breach was difficult or impossible to estimate in advance; and

2.     Whether the Liquidated Amount reasonably reflects the probable loss flowing from the breach.    

With respect to the first prong, damages are sufficiently “difficult to estimate” where they depend on a multitude of factors, fluctuate over time or if the ramifications of the breach are inherently speculative or unknown.  Where damages resulting from the breach are clearly identifiable and quantifiable before performance begins, a court may well determine that there is no reason for the liquidated damages provision and strike it down.

With respect to the second prong, the Liquidated Amount must constitute a “reasonable” estimate of damages – typically evidenced by some chance that the actual damages will be higher or lower than the Liquidated Amount.  If the Liquidated Amount is grossly disproportionate to the foreseeable harm, however, the provision is likely to be struck down as an unenforceable penalty.

A common error when evaluating the reasonableness of liquidated damages provisions is to compare the amount of actual damages (calculated after the fact) to the Liquidated Amount with the benefit of hindsight.  Courts will not play “Monday morning quarterback” and neither should the parties, who are generally bound by the bargain they struck pre-contract even if actual damages end up being much higher or lower than the Liquidated Amount.  Indeed, if a liquidated damages provision is enforceable, actual damages stemming from the same breach are not recoverable.

Generally speaking, liquidated damages provisions are upheld in private construction as owners face potential lost profits, construction loan interest and loss of use, which are inherently difficult to estimate.  In public construction, by contrast, potential loss is not as easy to show, as there are no lost profits and rarely ever construction loans.  Public owners, in general, must therefore work harder to justify that a Liquidated Amount reasonably forecasts its anticipated losses.

In light of the foregoing, to help ensure that contractual liquidated damages provisions are enforced, parties should consider adding explicit language to their contracts stating that, in the event of a specific breach, damages would be difficult to ascertain.  They can also explicitly state that the Liquidated Amount is a fair and reasonable estimate of likely damages flowing from the breach.   While these assertions are not dispositive, they should assist in enforcement while weighing against a finding that the provision constitutes a penalty.  

How are Liquidated Damages for Delay Calculated?

A large part of the effort in recovering on a claim for liquidated damages for delay is quantifying delays against contract milestones, allocating those delays between the parties and accounting for any unique contract specifications impacting their calculation.  Owners and contractors should work with their counsel and experts to address the following questions in the event of a delay claim: 

1.    What were the delays to the milestone dates in the contract, and were they altered by any change orders, contract amendments or other extensions of time?  Milestone dates may be modified by agreement between the parties or recognition of “excusable” delays.  Often, however, entitlement to time extensions becomes a hotly contested issue requiring a third-party neutral to determine whether the owner or contractor was in fact entitled to an extension that would shorten or eliminate a period of alleged delay.    

2.    What was the cause of the missed milestone and which party was responsible?  Even where a contractor misses a milestone without an extension, it is not automatically liable for liquidated damages.  The general rule is that liquidated damages will only accrue where delays are caused exclusively by the breaching party.  In instances where both parties caused delays to a milestone during the same time period, those “concurrent” delays are not allocated specifically to either party and are generally not recoverable.   

3.    Does the contract specify a limitation on liability for liquidated damages or different Liquidated Amounts for different milestones?  Contracts will sometimes place an upper limit on the amount of liquidated damages that can be claimed.  Moreover, because not all milestones are of equal importance, contracts may assign different Liquidated Amounts to each one.  These limitations and specifications must be identified and appropriately applied.

After determining the delays against applicable milestones, the governing contractual rates and any contractual cap, calculating the total amount of liquidated damages becomes a matter of relatively straightforward arithmetic.  It is the inputs into this calculation that are most often subject to dispute and litigation. 

Performing the above analysis will typically require the assistance of an independent schedule delay expert who can determine the causes of delays to the liquidated damages milestones and apportion responsibility between the parties.  These experts will work with counsel to independently determine the delays to contractual milestones and the resulting damages given the unique circumstances of a given project.

Conclusion

In a perfect world, every project would finish on time and under budget.  In reality, a basic understanding of what liquidated damages are, when such provisions are enforceable and how they are calculated is likely to serve you well.