Owners and contractors frequently treat liquidated damages provisions as an afterthought, but they deserve to be treated as a key deal term. If a contractor breaches a contract by failing to complete the work in a timely manner, the remedy is typically an agreed upon amount or rate of liquidated damages.

Liquidated damages provisions seldom get more than a cursory, “back of the napkin” analysis, or worse, parties will simply plug in a number. This practice is dangerous because liquidated damages typically represent the owner’s sole remedy for delay and, more importantly, they are subject to attack and possible invalidation if certain legal standards are not met. The parties to a construction contract should never agree to an amount of liquidated damages without first attempting to forecast and calculate actual, potential damages.

Liquidated damages are a substitute for the “actual damages” an owner would otherwise be able to recover in the event of unexcused project delay. They are intended to provide a measure of damages that otherwise would be difficult and costly to ascertain. In some jurisdictions (e.g., California) liquidated damages provisions are presumed valid unless the contractor establishes that the provision was unreasonable at the time of contract.

Because liquidated damages must be compensatory and cannot constitute a penalty, the amount of liquidated damages must represent a reasonable estimate of anticipated delay damages under the circumstances at the time of contract formation. This requires that the parties make a reasonable estimate of delay damages when they are negotiating key deal points. Amounts that have no explanation or are purely speculative may not suffice.

Failure to Properly Quantify

All too often, a negotiation of liquidated damages goes as follows: A party throws out a number during the late stages of contract negotiation without any explanation for why that number is appropriate (perhaps it was used on a prior contract), and then the other party argues that proposed number is too high or objectionable. The parties then engage in a superficial back and forth exchange and eventually compromise on a number, hopeful that the subject of liquidated damages will never come up again. At the time of contract, owners and contractors often fail to analyze and quantify the owner’s potential delay damages under various delay scenarios. This approach to liquidated damages is woefully deficient.

Liquidated damages are preferred in the construction industry because they remove the need for costly and expert intensive disputes over the extent and amount of actual delay damages. But the simplification and cost savings afforded by the avoidance of this “damage” phase of any legal proceeding does not obviate the need for attentiveness to the amount of liquidated damages.

From the owner’s perspective, liquidated damages may be intended to compensate for, among other things, lost revenue, extended costs for construction administration and management, extended financing and refinancing costs, lost tax incentives/advantages, governmental penalties, damage to reputation, lawsuits and legal fees, additional insurance costs and lost opportunity costs.

From a contractor’s perspective, the amount of liquidated damages should be sufficient to motivate a contractor that is behind schedule to accelerate the work and get back on schedule. If the amount of liquidated damages is too low or capped, a contractor might make a rational choice to allow itself to be assessed liquidated damages rather than spend the cost to accelerate the work. On the other hand, if the amount of liquidated damages is too high, a contractor might quickly find that the assessment of liquidated damages poses an unexpected risk to its financial stability.

Belated objections to liquidated damages that were not analyzed at the time of contract may not save contractors from liability for substantial amounts.

Case in Point

A recent project illustrates these dangers. A contractor agreed to construct a 300-unit multifamily project comprised of six phases for a guaranteed maximum. The liquidated damages provision provided for the assessment of liquidated damages on a phased basis according to phased milestones. For example, phases one through four could be timely and subject to no liquidated damages and if phases five and six were late, then liquidated damages would only be assessed against those phases.

This phased assessment of liquidated damages (instead of tying liquidated damages to the completion of the entire 300-unit project) was an attempt to make the liquidated damages provision a more reasonable estimate of anticipated, actual damages. However, if all of the phases were late, the phased assessment of liquidated damages totaled approximately $40,000 per day. The project had a two-year baseline schedule, but completion of all phases was delayed one and a half years.

This delay left the contactor subject to approximately $22 million in liquidated damages, an objectively high amount measured against a $45 million project. At trial, the contractor vigorously argued that the liquidated damages provision was a penalty and was not a reasonable estimate of anticipated damages. For example, the contractor’s expert witnesses argued that the liquidated damages provision should be invalidated because liquidated damages could hypothetically be assessed against an entire phase even though 50 of 51 units in the phase were substantially complete, a manifestly unfair result.

In response to the contractor’s arguments, the owner countered that based on the contractor’s flawed reasoning, no phased liquidated damages provision could ever be valid. The owner also argued that contractor’s analysis was retrospective and not based on considerations at the time of the contract.

Most importantly, the owner presented evidence of a detailed pre-estimate of its delay damage exposure at the time of contract. The owner explained each of the unique categories of damage it considered in evaluating and calculating the amount of liquidated damages, including approximately $10 million in affordable housing penalties if it failed to complete construction by a certain date.

At trial, the contractor pounded on the owner for failing to provide any contemporaneous documentation (no emails, writings or spreadsheets) of its alleged damage analysis from the time of contract. The owner relied primarily on the testimony of its principal about what he considered at that time of contract negotiation. Fortunately for the owner, the trier of fact found the testimony of its principal credible and refused to invalidate the liquidated damages provision. That result was far from certain.

Several lessons for contractors and owners are discernable from this trial.

• Meaningfully analyze and calculate anticipated delay damages at the time of contract;
• document that analysis and calculation in writing (a spreadsheet would be good);
• focus on the delay scenarios most likely to occur, but do not ignore improbable worst-case scenarios; and
• do not treat liquidated damages as an afterthought.

By giving liquidated damages provisions the thought and attention they deserve, owners will insulate their liquidated damages provisions from legal attack, and both owners and contractors will protect their bottom lines.