Liquidated Damages In Construction Contracts Part 1 - What Are Liquidated Damages And Why Have Them
Liquidated damages are a pretty frequent feature in construction contracts. Love them or hate them, you hear about them. Sometimes you live with them. This post and the next will look at some of the frequent nagging questions and issues you're likely to have involving liquidated damages, including:
- What are liquidated damages?
- Why you might use liquidated damages?
- How to increase the odds that your liquidated damages clause will be enforced.
What Are Liquidated Damages?
Liquidated damages are an amount of money that contracting parties agree on as the amount of damages one of them can recover if the party breaches the contract. Usually they apply to some specific type of breach of the contract, not any breach of any promise anywhere in the contract. In construction contracts, you'll most often see liquidated damages apply when the contractor breaches the contract by not finishing the work on time.
Frequently you'll see some formula for liquidated damages. For instance, $1,000 per day that substantial completion is late. If the prime contractor is five days late in substantially completing their work, they owe the owner $5,000. The owner usually deducts the $5,000 from a payment to the contractor. I can't recall ever seeing a contractor actually pay liquidated damages to an owner. I'm sure it's happened. But I haven't seen it yet.
What I do see often though are disputes over liquidated damages. They usually center around two issues: (1) whether a contract's liquidated damages clause is enforceable and (2) how much in liquidated damages does one party owe the other.
Why Have Liquidated Damages In A Construction Contract?
Some reasons for using liquidated damages:
- Both parties know up front what the damages will be for the applicable breach.
An owner knows that if the contractor finishes late, the owner needs only a calendar and their fingers (or a calculator) to identify the amount of their damages.
Contractors know from the outset how much "exposure" they have if they finish the work late. They can use that information to prepare their schedules, deploy their forces, and schedule the timing and sequence of subcontractor work. Moreover they also know how much they have at risk.
- Proving the amount of actual damages from late substantial completion is often very difficult. You can avoid that difficulty by using liquidated damages as a substitute.
Traditional Anglo-American contract law requires that damages be proved with reasonable certainty. And courts deny damages that are too speculative. This makes proving damages from late substantial completion very hard in most cases.
For example, imagine the project is a new auto dealership. The contractor substantially completes the work 15 days late. The owner expected to open and operate the dealership during those 15 days and earn profits selling cars to the public (yes, even in today's market there are still some car buyers and profits to earn selling to them).
Among other things, the owner will claim as damages the profits they lost during those 15 idle days. But can the owner prove, with reasonable certainty, what their sales volume and profit margin would have been during those 15 days? Can they prove their costs would be as low as they claim? Can they prove that the cars, accessories, and related services they offer at that location, during those particular 15 days, would have sold at the prices the prices they? Can the owner prove that other factors outside their control, like bad weather, would not have depressed sales during some of those 15 days?
Maybe the owner can prove these things, but it's pretty speculative. And if the owner's proof is speculative the contractor will oppose saying its not reasonable certain. Agreeing in advance on liquidated damages avoids trying to prove things that, at best, are speculation.
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Using liquidated damages is usually less expensive than proving actual damages. Proving actual damages is not only difficult, it's expensive. It usually involves a lot of time and a lot of professionals' fees and costs (e.g., lawyers, consultants, expert witnesses, travel, deposition transcripts, document production and copying). If you overcome the difficulty proving actual damages, you're still left with the cost of proving them. And to identify your net recovery, you must deduct all of those fees and costs you've already spent from the actual damages you actually collect. Keep in mind that the spending usually comes before the collecting. And there's no guaranty that after successfully proving your actual damages that you'll ever collect any of them. With liquidated damages as a substitute, for actual damages, you spend less on proving the amount of your damages.
- Liquidated damages can be a good substitute for "consequential" damages.
They're a special sub-category of actual damages. If dispute over actual damages are a tornado, disputes over consequential damages are a hurricane. We'll talk more about what consequential damages in a future post. Just take my word for it for now that they arouse a lot of expensive and protracted controversy. They're so controversial that starting in 1997 the American Institute of Architects has put a waiver of consequential damages in its most popular form of construction contract, the A201.
By including expected consequential damages within the amount of liquidated damages, you can often avoid controversies over consequential damages.
But liquidated damages don't fit every situation. Sometimes even if they do fit, one side won't agree to them or the parties can't agree on the amount.
If you do agree on liquidated damages, you'll probably expect them to be enforced. What's the use of avoiding the time and expense of proving actual damages to just spend it instead on disputes over getting liquidated damages enforced. That's the subject of the next post.
Construction Law Today is a legal blog about construction contracts, disputes, finance, and the people whose job it is to deal with them.
