Few concepts in the construction industry are as universal and fundamentally misunderstood as liquidated damages.
It is important to understand the basic definition of a legally enforceable liquidated damages clause. Liquidated damages are a reasonable pre-estimate of the actual damages that would likely be sustained in the event of a delay, particularly when the actual damages would be difficult to determine. When both parties sign a contract with a liquidated damages clause, they are accepting the reasonableness of the liquidated damages.
The goal of a proper liquidated damages clause is to consolidate into one fixed and mutually predetermined amount the entire universe of damages that the owner reasonably would expect to incur due to an unexcused delay to the completion of the project, to the exclusion of a right to recover any other damages due to that delay. In simple terms, if the contract provides for liquidated damages of $1,000 per day of unexcused delay and the owner incurs actual damages of $1,750 per day, the owner may only recover $1,000 per day.
To accomplish this intent, there are several critical elements. First, liquidated damages must be provided for in the contract. Second, the liquidated damages clause should expressly state that recovering liquidated damages is the owner’s sole and exclusive remedy in the event of such a delay. In other words, if a delay of the type described in the liquidated damages clause arises, the owner should not have the option of choosing whether to assess liquidated damages or to seek actual damages (or both). A well drafted liquidated damages clause eliminates that choice.
It also is good practice to couple a liquidated damages clause with a mutual waiver of consequential damages. This waiver may be part of the liquidated damages clause itself, though it is usually located elsewhere in the contract. To understand the importance of this pairing, it is important to understand that consequential damages are one of the largest risks a contractor can face on a construction project.
Liquidated damages typically cover only the owner’s “direct damages,” i.e., damages that flow directly from the delay, such as extended owner’s representative costs, extended engineering or architectural costs, insurance costs, loan interest and other carrying costs. An owner’s consequential damages, on the other hand, are “indirect” damages such as lost profits, lost revenue, lost business opportunity, etc., incurred as a secondary impact of the project’s delayed completion. The liquidated damages clause should make clear whether the liquidated damages cover only direct delay damages or all delay damages including consequential damages.
A mutual waiver of consequential damages can limit damages exposure considerably with or without a liquidated damages clause. However, when the two are coupled, the contractor’s delay damage exposure to the owner is clearly limited to the liquidated damages.
Furthermore, a mutual waiver of consequential damages precludes an owner from seeking to recover more than liquidated damages in the event of a covered delay. For this reason, it is good practice to include in a mutual waiver of consequential damages provision an express statement that the waiver does not include nor prevent recovery of liquidated damages. In so doing, the consequential damages waiver essentially acknowledges that liquidated damages are intended to encompass all applicable consequential damages and reaffirms that the liquidated damages clause is the sole and exclusive remedy for delayed completion.
Liquidated damages clauses should expressly define the event of delay that triggers the ability of the owner to assess liquidated damages against the contractor. Conceptually, as liquidated damages generally are intended to cover damages that the owner reasonably estimates it will incur due to delayed project completion, the triggering event should be an actual, not merely potential, delay to the project’s completion. However, owners often draft liquidated damages clauses that are triggered by a delay to interim milestones. In such situations, the owner will assess liquidated damages against the contractor mid-way through the project for the contractor’s failure to achieve timely completion of an interim milestone, even though the contractor is able to make up the time and ultimately achieve timely substantial completion.
As liquidated damages generally are intended to cover damages that arise from delay to the completion of a project, contractors negotiating such clauses with owners should push for language that makes the contractor’s failure to achieve substantial completion a condition precedent to the applicability of the liquidated damages clause and the owner’s right to assess such damages.
In the current market, contractors and owners often negotiate a grace period (e.g., 30 days) following the substantial completion date, where liquidated damages will not be assessed unless the contractor fails to complete by the end of the grace period. For the contractor, the benefit is obvious. For the owner, providing a grace period provides added incentive to a contractor to expedite completion to avoid paying liquidated damages for the grace period.
Similarly, contractors will often negotiate a cap on liquidated damages, ideally tied, in some measure, to the contractor’s anticipated profit on the contract. Such a cap maintains sufficient incentive to the contractor to do all it can to achieve timely substantial completion, while also providing some measure of downside protection and avoid unchecked liquidated damages exposure that may substantially exceed the actual damages the owner incurred due to the delay.
As liquidated damages are established by the written contract between two parties, its survival beyond the conclusion of that contract is not automatic. Thus, where the liquidated damages clause does not expressly provide that the clause survives termination, an owner anticipating far greater, actual delay damages than is provided for in the clause may seek to avoid the limitations of the clause by terminating the contractor. Providing for the survival of liquidated damages in the event of a termination by the owner eliminates that option.
If project completion is delayed by the inadequacies of a subcontractor’s performance, the general contractor will certainly seek recovery from the subcontractor of the liquidated damages that the prime contractor must pay to the owner. However, the contractor likely will incur more damages due to the delay, such as extended general conditions, escalation, inefficiencies and claims by other subcontractors impacted by the delay.
To respond to the risk of those damages, the prime contractor and subcontractor should decide during subcontract negotiations whether the prime contractor’s recovery will be limited to the owner assessed liquidated damages or to all damages incurred by the prime contractor due to the subcontractor’s delay, including but not limited to the owner assessed liquidated damages. Simply “cutting and pasting” the prime contract’s liquidated damages clause into subcontracts is not an appropriate way to handle this issue.
Consideration of the prime contractor’s exposure to the owner’s consequential damages (if not waived) also must be considered. Thus, from the prime contractor’s perspective, it is advisable to include a broad form indemnity provision in the subcontract that expressly states that the indemnity obligation includes any liquidated damages and/or consequential damages that the owner may assert against the prime contractor due to the subcontractor’s performance or failure to perform its obligations under the subcontract.
This article is a high-level discussion of a few of the more common issues encountered when dealing with liquidated damages clauses. As with most complex contractual clauses, consult with legal counsel to achieve a fair and enforceable liquidated damages provision and assure the company is properly managing the assessment of the risk of liquidated damages.
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