When Properly Drafted, Liquidated Damages Provisions Reduce Risk
Utilized properly, liquidated damages provisions strengthen construction agreements because they provide a degree of certainty. Additional certainty lowers risk and allows the contractor to reduce contingency reserves which, in turn, reduce project costs while protecting the builder’s profitability. Too often, however, liquidated damages provisions are misunderstood, poorly drafted, and can be the genesis for costly disputes. This article will provide practical advice about liquidated damages provisions.
According to legal precedent, liquidated damages provisions are supposed to be used only where actual delay damages are difficult to determine at the time of contract execution. That is almost always true for construction projects. The benefit for contractors is that liquidated damages quantify the contractor’s potential exposure to delay damages at contract execution. This improves the prime contractor’s ability to mitigate the risk through contingency reserves and by reallocating risk for delay to its subcontractors.
In practice, after delays occur, owners would often prefer to seek actual damages – once actual damages can be determined. Accordingly, the language used in liquidated damages clauses must clearly state that the owner’s sole recovery for delay damages is the amount established by the provision. An owner can still recover other damages unrelated to delay, such as for correction of non-compliant work.
Another legal constraint is that the amount set by the liquidated damages provision must be a “reasonable estimate” of potential actual damages and not a “penalty” for the builder’s failure to timely complete the project. In practice however, these parameters are not often highly scrutinized given the fact that liquidated damages provisions are supposed to be used only where damages are difficult to forecast. Still, the parties should consider these guidelines when they negotiate liquidated damages provisions and agree on some reasonable bases for the calculation, in the event the amount set is later challenged.
Another concern for the owner is making sure the liquidated damages are sufficient to compel the builder to incur additional costs for accelerating the work if the construction project falls behind schedule. If the builder’s anticipated costs to accelerate the work are higher than the liquidated damages, the builder has no financial incentive to finish the project on time.
There should be no ambiguity concerning the date triggering an award of liquidated damages. The completion deadline must be tied to an objectively determinable milestone. Most often, it is the date of “substantial completion,” which is usually defined by the contract or, if not, is defined by the industry as the date the owner has use or access to the project or some portion of the project. If final completion is utilized as a milestone for award of liquidated damages, there needs to be some independent, objective criteria for establishing that date. No matter the date used, it must be adjusted to track all agreed changes to the project schedule.
Liquidated damages should be calculated on a per (calendar) day basis and should have a limit on the total amount of damages that can be awarded. Below is an example of contract language that addresses the issues raised by this article.
The Parties acknowledge that Owner’s damages for delay are difficult to determine as of the date of this Agreement. The Parties agree that a reasonable estimate of Owner’s potential damages for delay is $_____ per day commencing on the day following the date set by this Agreement for Substantial Completion (the “LD Date”). This is a good faith estimate of Owner’s potential actual damages and is not a penalty. In the event of delayed Project completion, this amount shall be paid by Builder to Owner. It is also agreed that the LD Date shall be adjusted on a day-to-day basis by Change Orders impacting the date of Substantial Completion. Builder shall not be liable for any delay damages (including all Owner’s consequential damages related to delayed Project completion) except as provided by this provision. Notwithstanding anything set forth in this provision, however, the total amount of liquidated damages for delay that can be due from Builder to Owner shall not exceed $________.
Please contact William J. Tinsley, Jr. or any member of the Phelps Construction/Design team if you have questions or need advice or guidance.
