For the Client—Liquidated Damages Clauses Can Help Owners Manage Risk

 

April 2012

COMMUNITIES: PRIVATE PRACTICE
For the Client—Liquidated Damages Clauses Can Help Owners Manage Risk

BY MICHAEL DOLAN AND TIMOTHY BRINDLEY

 

MICHAEL DOLAN
Michael Dolan
TIMOTHY BRINDLEY
Timothy Brindley

As an owner, you ideally want projects completed on time and according to specification, however, these goals aren't always met. When construction is delayed and the contractor fails to complete the project by the completion date, a "liquidated damages" clause can act as a highly effective risk management tool in construction contracts. Whether the project involves a home, school, or other facility, a liquidated damages clause allows you to mitigate the uncertainty of delay damages resulting from a contractor's failure to meet the completion date.
 
Liquidated damages are damages that must be specifically defined in the construction contract. A liquidated damages clause fixes the amount of damages to be paid by one party to another upon the occurrence of specified events. In a construction contract, this event is typically the contractor going beyond the scheduled completion date to finish the project. The liquidated damages clause will stipulate that for every day the contractor goes over the completion date, the contractor will be charged a certain amount. This provides a relatively straightforward method of calculating damages recoverable by the owner in the event of a late completion but also helps to limit the contractor's risk and/or exposure. Essentially, both parties to the contract start the project with a clear understanding of what the contractor will pay in the event of a delay. The certainty of knowing this before the project starts is valuable. Proving the amount of actual damages for late completion can often be very difficult for the owner and will usually involve a lot of time and professionals' fees (including attorney's and expert's fees). The simplicity of the liquidated damages clause allows the owner to easily calculate damages to be assessed to the contractor. To create an enforceable liquidated damages clause, there are typically three requirements in most jurisdictions.
 
The first requirement is fairly simple: The contracting parties must actually intend the specific clause to be a liquidated damages clause. This requirement is meant to ensure that both parties are aware of the implications of such a contract. When dealing with an experienced contractor, it is very easy to prove this because they are common in the construction industry, and the contractor should be expected to appreciate the consequences of such a clause.
 
The second and third requirements can be more difficult to prove and are usually the basis of disputes over enforceability of the liquidated damages clause. The two requirements are that the liquidated damages clause may not act as a punishment and must be reasonable at the time of the creation of the contract.
 
The policy behind the liquidated damages clause is not to create a penalty for a contractor's failure to complete the project by the completion date (although, it may appear to act this way in practical application). Its purpose is to compensate the client or owner for the damages associated with the delay at the outset of the contract because of the difficulty in being able to prove them with certainty later on. Excessively large liquidated damage amounts will, therefore, not usually be upheld by the courts because they appear to be a penalty, not compensation for the owner.
 
An owner can show that a liquidated damages clause was not punitive by displaying that, at the time of its creation, it was a reasonable and genuine estimate of what the owner's loss would be. Even if the actual damages appear to be less than the liquidated damages clause, a showing by the owner of its reasonableness at the time of the contract formation will usually allow the clause to stand. Reasonableness of the amount can be shown through documentation of calculations or estimates showing projected damages associated with a delay. This will most certainly help in proving that the damages amount was well thought out and based on reasonable estimates of the risk. On some occasions there are actually good faith negotiations with the contractor to help establish what is a fair risk for both parties to bear. But more commonly, the liquidated damages are unilaterally set by the owner.
 
In calculating a reasonable amount for damages associated with delays, owners should consider all the facets of the project that may be affected. These factors include the difference between construction period interest and permanent loan interest, temporary rental and relocation costs, lost profits, damages payable for holding over at a prior location, costs associated with multiple moves, and project administration costs, including inspection fees. For more complex projects, the liquidated damages provision should differentiate damages in the event of late completion or partial completion and how it is apportioned between the different stages of work, or similarly by reducing the amount by the proportion of the project that has come under the owner's possession.
 
Liquidated damages are a highly effective risk management tool for clients and provide an easy back-of-the-envelope way of determining delay damages, which may help owners avoid excessive fees associated with litigation.
 
Michael Dolan is partner and Timothy Brindley is an associate in the New Brunswick, New Jersey-based law firm Hoagland, Longo, Moran, Dunst & Doukas LLP.