What are liquidated damages?
Liquidated damages are presented in contracts as an estimate of hard-to-calculate or intangible losses of one of the parties. A liquidated damages clause benefits all parties to a contract by by defining downside risk by eliminating the need to spend resources and time calculating actual damages if one party breaches the contract. In this article, our contract attorney in Los Angeles explains liquidated damages and how to determine whether it is enforceable.
A liquidated damages clause is common in today’s construction contracts, both in the public and private sectors. They serve as a helpful tool for contractors and owners to establish and allocate risks in case of a contract breach. It is crucial for participants in the construction industry to have a solid understanding of the liquid damages clause to effectively execute, negotiate, or potentially litigate their contracts.
In the simplest example, John hired Mr. Contractor to build a house to be completed by July 5, 2024. They entered into a written contract that has a liquidated damage provision. The provision states, “For each day Mr. Contractor is late in building the house, Mr. Contractor has to pay John $500 in liquidated damages.
Broadly, liquidated damages clauses outline a predetermined sum of money that needs to be paid as compensation if one group does not fulfill specific contractual obligations. In contracts related to construction, this often takes the form of a fee per unit of time (referred to as the “Liquidated Amount”) in case a milestone is missed, like achieving Substantial Completion. Typically, the Liquidated Amount is shown as a daily rate. These damages can also be linked to performance metrics, like availability of a project or facility, efficiency, and output. For instance, according to the liquidated damages clause, there might be a stipulated fee if a facility generating power fails to supply the agreed-upon output of power. A liquidated damages clause can also entail “specific-performance,” such as carrying out a specific action upon a breach or forfeiting a deposit.
The primary aim of a liquidated damages clause is to enable groups to mutually agree, right from the start of their partnership, on a reasonable and just damages estimate that would otherwise be complex or even impossible to compute accurately. In essence, a liquidated damages clause is beneficial to both groups by outlining the potential negative risk, while avoiding the need to dedicate resources and time in calculating actual damages and proving them through potentially costly process of dispute resolution.
In the event of liquidated damages due to delays, construction contracts generally stipulate a deadline for meeting schedule milestones and lay out criteria for determining when they have been accomplished. A liquidated damages clause’s criteria may encompass completing a defined scope of work, obtaining necessary permits (like an occupancy certificate), or obtaining owner approval for project closure documentation (like a final application for payment or a certificate of substantial completion). Liquidated damages will start to accumulate should a milestone be missed and will persist until the milestone is achieved or a liquidated damages contractual cap is met.
Liquidated damages clauses for performance metrics also will typically spell out the circumstances under which performance is gauged and/or the timeframe within which performance-related liquidated damages can be imposed. When reviewing a contract related to construction, industry participants would be prudent to ensure that triggering events, contractual milestones, and all aspects of their liquidated damages clause are as precise as possible. This aids in enforcing the contract and diminishes the chance of an argument.
How to determine if a liquidated damages clause is enforceable?
While freedom of contract is a fundamental principle in American legal practice, contracts entered into by experienced parties are usually upheld as written. However, a liquidated damages clause will not be honored if it is deemed to be a “penalty.” The central question in determining whether as liquidated damages clause is a penalty centers around whether it was intended to estimate damages in case of a violation or to function as a figurative threat, coercing continued performance from a contractor.
In examining this issue, courts place themselves in the position of the parties at the time the agreement was established and consider two main factors:
- Whether it was inherently hard or impossible to predict the loss resulting from the breach in advance; and
- Whether the specified Liquidated Amount reasonably corresponds to the likely loss arising from the breach.
Regarding the first aspect, damages are considered “hard to estimate” when they rely on various factors, change over time, or if the consequences of the violation are unknown or speculative. If the damages resulting from a breach are easily quantifiable and identifiable before performance commences, a court may decide that there is no need for the liquidated damages clause and may invalidate it.
Regarding the second aspect, the Liquidated Amount must represent a “reasonable” damages estimate—typically supported by some chance that the actual damages could be higher or lower than the specified amount. However, if the Liquidated Amount is significantly disproportionate to the predictable harm, the liquidated damages clause is likely to be invalidated as a penalty that cannot be enforced.
A common mistake in assessing the reasonableness of liquidated damages clauses is using the benefit of hindsight to compare the actual damages (computed after the fact) to the Liquidated Amount. Courts do not engage in retrospective evaluation, and parties should likewise adhere to the agreement they made prior to the contract, even if actual damages turn out to be significantly different from the Liquidated Amount. To be sure, if a liquidated damages clause is valid, actual damages resulting from the same violation cannot be recovered.
In private construction, liquidated damages clauses are generally upheld, as owners face potential losses in terms of construction loan interest, profits, and loss of use, which are inherently hard to estimate. In public construction, however, demonstrating potential loss is more challenging, as there are typically no lost profits and hardly any loans for construction. Therefore, public owners usually need to provide stronger justification for how the Liquidated Amount reasonably predicts their expected losses.
Given the above, to enhance the likelihood of enforcing contractual liquidated damages clauses, parties should think about incorporating explicit language in their contracts stating that, if a specific violation occurs, determining damages would be challenging. They may also clearly say that the Liquidated Amount represents a reasonable and fair estimate of the expected damages arising from the violation. While these statements are not conclusive, they can support enforcement while working against a finding that the liquidated damages clause makes up a penalty.
How are liquidated damages determined in case of delay?
A significant portion of the process involved in pursuing a claim for liquidated damages due to delays revolves around assigning numbers to the delays against milestones in the contract. This includes assigning these delays among the involved parties and considering any specific liquidated damages clauses that may affect their computation. Contractors and owners should collaborate with their legal representatives and experts to respond to the below questions in case of a delay allegation:
- What were the postponements to the milestone dates in the agreement, and were they affected by any contract amendments, change orders, or other time extensions? Milestone dates may be adjusted through mutual agreement or acknowledgment of “excusable” delays. However, the entitlement to time extensions often becomes a contentious matter, necessitating a neutral third party to determine whether the contractor or owner was indeed entitled to an extension that would nullify or shorten a period of supposed delay.
- What was the root cause of the missed milestone, and which group bears responsibility? Even in cases where a contractor does not meet a milestone without an extension, it does not automatically incur liability for liquidated damages. The basic rule is that liquidated damages only accumulate when delays are solely attributable to the party in breach. In situations where both sides contribute to delays in reaching a milestone during the same timeframe, these “concurrent” delays are not specifically assigned to either group and are usually not recoverable.
- Does the contract establish a cap on liability for liquidated damages or different Liquidated Amounts for various milestones? Contracts may occasionally set a maximum limit on the quantity of liquidated damages that may be claimed. Additionally, because not all milestones carry equal weight, contracts might assign varying Liquidated Amounts to each one. These specifications and limitations need to be identified and applied correctly.
Once the delays against relevant milestones, contractual rates, and any caps have been determined, calculating the total amount of liquidated damages becomes a matter of relatively straightforward mathematical calculation. It is often the variables in this calculation that become points of contention and subject to legal disputes.
Conducting the mentioned analysis usually requires the expertise of an independent schedule delay expert. This expert can ascertain the causes of delays to the liquidated damages milestones and allocate responsibility between the parties. They will collaborate with legal counsel to independently determine the delays to contractual milestones and the resulting damages, taking into account the unique circumstances of a particular project.
Conclusion
In an ideal scenario, every project would conclude on schedule and within budget. In reality, having a fundamental understanding of what liquidated damages entail, when such liquidated damages clauses are legally enforceable, and how they are calculated can be immensely beneficial.
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