As promised in the last post, this post is about ensuring you can enforce the liquidated damages clause in your contract. It’s also about other practical issues affecting liquidated damages and getting them to fulfill more of your expectations.
First, there’s nothing that will ensure liquidated damages will be enforced, or that they’ll do what you hope. Enforcement is at the mercy of judges. And if you don’t know already, they’re unpredictable. But there’s things you can do to better the odds. Or, if you’re opposing liquidated damages, lower the odds.
Principal Elements Of Enforceable Liquidated Damages
In most cases, enforceable liquidated damages must have 5 principal elements (this varies from state to state and country to country, so you and your lawyer must check applicable law very closely):
- Actual damages must be difficult to quantify.
- The amount must be liquidated (i.e., agreed on and set in advance)
- The amount must be reasonable
- They must be compensation, not a penalty
- They must be exclusive(i.e., the only remedy available).More on each of these below.
Difficult To Quantify
Usually, before you’re allowed to use liquidated damages, you must show that the actual damages you’d suffer are difficult to quantify. This requirement is honored more “in the breach” than in reality. Damages are often difficult to quantify, especially damages for breach of a construction contract. So, this element doesn’t usually arouse much controversy.
The amount of liquidated damages in your contract must actually be liquidated. By liquidated, I mean that in your contract you must set the amount of damages you’ll receive, or pay, if the other party, or you, breaches a specific promise in the contract. Liquidated damages in construction contracts are usually set in one of the following ways:
- Setting a simple fixed dollar amount – For example, if the contractor substantially completes their work late, they owe $50,000 in liquidated damages to the owner, or, if they’re a subcontractor, to the prime contractor. That’s simple and easy. But for many of the reasons I mentioned in a previous post on late payment interest rates, simple and easy won’t always fit the bill
- Setting by a formula – For example, if the contractor substantially completes their work late, they owe $1,000 for each day they’re late. If you use a formula, the simpler, the better. The more complicated it gets, the better the odds a judge will say that you didn’t liquidate the amount of damages, and decline to enforce what you though was a liquidated damages clause. My simplicity rule of thumb: if you need more than a copy of the contract, a pricing index on the Internet, a calendar, and a primitive calculator, your formula isn’t simple enough
The amount of liquidated damages you set must be reasonable. Great, another lawyer telling you that something must be reasonable. That’s sure is a lot of help. Thanks for nothing! I can’t give you an exact answer on what amount is reasonable and where it crosses the line into unreasonable. But the following are some guiding principles will help you:
- Your best estimate –
The amount you set should be your best and most realistic estimate of the damages you’ll actually suffer if the other party breaches the applicable promise in your contract. You make this estimate as of the time you enter into the contract. It doesn’t need to be an exact prediction; it just needs to be close.
This means that setting a liquidated damages amount is like a meteorologist forecasting the weather. You take the best data you have and forecast what will happen. You can’t be 100% sure. But you don’t have to be. You just need the best estimate you can come up with based on the information you have, or should have.
Ask yourself: “if the other party doesn’t do what they promised, what kinds of damages am I going to suffer? What kinds of costs will I have to pay? What’s the value of opportunities I’ll lose?
If you’re an owner estimating what damages you’ll suffer from late substantial completion of a project, you’ll need to consider things like the following:
- More construction loan interest – With the principal unpaid for longer, you’ll pay more interest for each day it’s unpaid
- Higher construction loan interest – If you don’t payoff your construction loan by a certain date, the lender may increase a fixed interest rate or an adjustable rate may increase. You might even default by not paying the principal before the loan matures. If that happens you’ll probably have to pay at even higher default interest rates
- Extra permanent loan fees – If you’re going to replace your construction loan with a permanent loan, that usually must wait until after substantial completion. If you wait too long, your permanent lender may charge you fees for extending your permanent loan commitment
- Higher permanent loan interest rates – Sometimes a permanent lender will not extend your loan commitment. So you’ll have to get different permanent loan terms. Maybe even a different permanent lender. Maybe with higher fees and interest rates
- Lost rent and sales –
- Rent lost from tenants who are not able to move in because their premises aren’t complete on time
- Loss of leases with tenants who may withdraw from their lease if their premises aren’t ready on time
- Lost sale of the project because the purchase contract requires completion before closing and the buyer may withdraw from the purchase if closing doesn’t occur by an “outside closing” deadline
- Fees, credits, and other concessions necessary to mollify tenants or postpone a closing deadline
Prepare to defend the reasonableness of your estimate – If you have to enforce liquidated damages, odds are you’ll have to defend the reasonableness of the amount to a hostile lawyer and a skeptical judge. Preparing to defend your estimate does two important things:
Keeps you from overestimating – Remember: pigs get fat, hogs get slaughtered. Restrain your estimate so it’s based on a well thought business case of what you stand to lose. It’s not a Holiday wish list and it’s not a hammer to hold over the head of the other side (more on that below)
Gets you ready for litigation – You’ll be in better prepared for your deposition where the opposing lawyer questions you about how you underwrote the amount of liquidated damages. You want to be able to explain the process of intense and comprehensive analysis you used to forecast what how much you’d suffer in damages if their client breached the contract
Not a Penalty
Anglo-American judges have told us for at least 100 years that damages for breach of a contract must focus on compensating for the party who didn’t breach the contract (for easy identification here we’ll call them the “victim”), not a punishing the party who breached the contract (and for easy identification here we’ll call them the “breacher”).
If a judges think the amount set for liquidated damages are really a penalty imposed on the breacher for breaching the contract, or a coercive device for deterring a potential breacher from becoming an actual breacher, that judge won’t enforce the liquidated damages.
It’s tempting to set a punitive or coercive amount for liquidated damages. We’d all like “a hammer” to hold over the other side. But if you succumb to this temptation, expect your liquidated damages to be unenforceable.
Be extra cautious when considering liquidated damages that increase as time goes on. For example, where liquidated damages are $1,000 per day for the first 5 days a contractor is late substantially completing their work, and then it goes up to $4,000 per day starting on the 6th day. These have the look and feel of a penalty. So if you use them, you’d better be prepared to explain how you estimated that the your damages would increase by 400% starting on the 6th day.
I often hear people involved in the design and construction industry refer to liquidated damages as “penalties”. They do this informally in the field, at meetings, and on the phone, and in their letters, e-mails, and sometimes even in their contracts too. Don’t!! If you and your people call liquidated damages a penalty, why shouldn’t the judge, and your opponents, take you at your word?
In many places, to be enforceable liquidated damages must be the victim’s exclusive remedy if the breacher breaches the applicable promise in the contract. The victim gets liquidated damages, and only liquidated damages.
If the contract provides the victim with an alternate way to measure their damages, chances are the liquidated damages will be unenforceable. A good example are cases about enforcement of liquidated damages under residential real estate sales contracts. In many of these cases the contract says that if the buyer breaches by failing to close, the seller may either (1) keep the buyer’s earnest money deposit as liquidated damages, or (2) recover the seller’s actual damages, whichever is greater. Judges often decide these liquidated damages are unenforceable. Though these cases don’t involve construction, the logic on exclusivity applies just the same.
But making liquidated damages your exclusive remedy puts you in a tough position. In addition to ensuring that the amount is reasonable and not a penalty, you must also ensure that the amount is enough to compensate you for the losses you think you’ll suffer if the other side breaches the contract. If your estimate is too low, you’ll be under-compensated.
The exclusive element is like jumping off a roof into a swimming pool. Once you step-off, you can’t stop half-way down. So, before you take that step, look to make sure the water, and the amount of damages set, are going to be deep enough when you land.
Caps on Liquidated Damages
Often I see caps on liquidated damages. They either won’t exceed some set maximum amount of money or an amount set by a formula or by reference to the value of some part of the work (like a contractor’s fee). Caps can be very helpful in getting contracting parties to agree to use liquidated damages and agree on the amount. But if you’re the potential victim, you must consider these two things:
- If damages reach the cap, will that be enough for me?
- What motivation does the breacher have to remedy the breach after liquidated damages reach the cap. They have no more liability to compensate my losses that go above the cap.
Gross vs. Net
It’s also worth mentioning that when deciding whether the amount of liquidated damages is enough, you must factor in the time and money savings from paying lower professionals fees and costs in pursuing your damages. A gross amount you know will under-compensate you may still yield a higher net by reducing your expenses for lawyers and damages experts, not to mention the value of the time you save and the uncertainty, anxiety, and anguish you spare yourself.
The following are some of my other observations from negotiating many liquidated damages clauses and reading many judicial decisions about successful, and unsuccessful, attempts at liquidated damages enforcement:
- Glazov’s Theorem of Symmetrical Damages – The greater the symmetry between (a) the amount liquidated damages set in your contract and (b) the damages you actually suffer, the better your odds the liquidated damages will be considered reasonable and not a penalty. The less symmetry, the more suspicion that they’re unreasonable and punitive. So, when setting the amount of liquidated damages, aim for perfect symmetry…..
- Top and bottom brackets – A lot of the difficulty in deciding on whether to use liquidated damages is you yourself deciding on the amount and then reaching agreement with the other side. It helps me to try and set a range for the amount between two brackets. The principal elements I mentioned above set those brackets.
- The reasonable and not a penalty elements set the top bracket. I know enforceable liquidated damages can’t go above this amount.
- The exclusive element sets the bottom bracket. I know that effective liquidated damages can’t go below this amount.
I find that putting liquidated damages within these brackets focuses my own thoughts, as well as the negotiations over whether to use liquidated damages, and where to set them.
- Setoff rights – If you’re paying money to the other party to your contract, consider language in your contract that allows you to setoff and withhold liquidated damages from money you owe them.
- Liquidated damages can save time and money. Proving how much actual damages is often uncertain, contentious, time consuming, and expensive. Using liquidated damages you might avoid each, or some, of these problems, either when proving your own damages, or limiting the damage claims of your opponent
- If you’re going to use liquidated damages, keep the five principal elements of enforceable liquidated damages in mind. Better yet, put language in your contract that affirms them. In your contract, have each party:
- Affirm that actual damages will be difficult to quantify
- Agree on setting the liquidated damages amount as a fixed sum, or using a simple formula
- Affirm that:
- The amount is reasonable. Identify the kinds of loss the victim will suffer if another party breaches the contract. Say that the liquidated damages are intended to compensate the victim for these and other injuries they suffer
- They have chosen the amount understanding, and intending, that liquidated damages will compensate the victim, not coerce or punish the breacher
- Liquidated damages will be the victim’s exclusive compensation if the applicable type of breach occurs
- If you are the likely victim, consider language allowing you to setoff liquidated damages against payments to the breacher
- If you’re using an AIA contract document, consider editing the waiver of consequential damages to avoid the confusion that comes from the mention of “liquidated direct damages”