Liquidated Damages

The party who has suffered a loss because the other party to his contract has breached the contract in some respect is entitled to recover damages. The measure of damages is usually the dollar value of the loss suffered.

In the context of a construction contract, the loss or "damages" recover able may consist of several elements, including loss of income which would have been earned had the project been completed on time, the cost of remedial work necessitated by failures to complete construction in either a workmanlike manner or in accordance with applicable plans and specifications, or the cost of having completion work performed by others where the contractor or subcontractor failed to complete.

Damages for delay incurred as a result of a contractor's failure to finish construction within the time provided by contract are frequently difficult to measure with mathematical precision. This is because of the existence of many unknowns. For example, if the project involves an office building being built for an owner who intends to lease offices to various tenants, it would be difficult to calculate precisely the owner's loss occasioned by an unexcused delay in completion of the building. Questions concerning how quickly offices could be rented, the costs of maintenance and repair, rental rates, and the like may not be readily predictable or even determinable with hindsight.

Accordingly, it is customary for construction contracts to provide for liquidated damages in the event of unexcused delays in the completion of construction. The concept of liquidated damages is that the parties to a construction contract agree, in advance when their contract is made, that of the construction is delayed the owner would likely suffer damages of a predetermined number of dollars for each day, week, month or year of delay.

The construction contract would contain a liquidated damages clause fixing either a specific dollar amount of damage for delay or some other method for objectively fixing the owner's loss based upon a fixed calculation formula.

Customarily, such a provision would recite that if construction is delayed beyond a fixed completion date without sufficient excuse, the owner would be entitled to recover liquidated damages in the amount fixed for each day of delay.

The advantage of a liquidated damages clause to the contractor is that he would know precisely what his risk might be if his work is delayed. Similarly, the owner would know the dollar amount to which he would be entitled in the event of delay. Both parties might save the expense which would otherwise be incurred in proving or disproving the actual dollar amount of damages in court or by arbitration. With this precise knowledge they may even be able to avoid costly litigation or arbitration expenses and thus be in a better position to "amicably" resolve their differences.

Naturally, a construction contract containing a liquidated damages clause must include a fixed or easily determinable date for completion. The contract should likewise include provisions excusing delays for circumstances beyond the contractor's control such as strikes, shortages or unavailability of materials, fires, floods and other acts of God or circumstances beyond the contractor's control.

In fixing the completion date the parties should be realistic, avoiding too much risk for the contractor and unreasonable expectations for the owner.

Both the owner and contractor should carefully consider both the use and impact of a liquidated damages clause. The dollar amount of liquidated damages should be established with reference to the reasonably expected loss which the owner might incur in the event of a delay. While the use of a liquidated damage clause is likely to prompt the contractor to meet the construction time schedule, the dollar amount should not be so high that it would unduly penalize the contractor.

Liquidated damages amounts which impose unreasonable penalties upon the contractor rather than reasonably compensate the owner for his delay losses are usually not legally enforceable. It is not unusual for courts and arbitrators to completely ignore liquidated damage provisions containing daily dollar amounts inserted arbitrarily and without consideration of the reasonable amount of damages the owner might sustain because of delay.

Consider, for example, a case where the project involved is a public school. Suppose that the construction contract contains a $300 per day liquidated damage provision inserted without any serious thought by either the owner, its architect, who drafted the provision, or the contractor. Assume also that the school building is to replace an older but still usable school building. To claim that the school district owner might have suffered a $300 per day loss for any period of construction delay would, under those circumstances, be highly questionable.

In contrast, however, a $300 per day liquidated damages provision might be reasonable if the project involved is a large manufacturing facility with seasonal operation peaks.

The general rule followed by most courts is that the fixed dollar amount of liquidated damages bear some reasonable relationship to the amount of damages which the owner could have predictably suffered in the event of construction delay.

In contract negotiations the parties should consider what predictable loss the owner might suffer if construction is delayed. Items to be considered would include loss of net income (total income less operating costs), interest costs for borrowed monies or the difference between the cost of construction financing and long-term financing interest.

Also, substitute rental expenses which the owner may incur in premises occupied during an extended period necessary for construction completion, potential inflationary factors, seasonal effects of delayed completion, possible loss of long-term financing or potential interest rate in creases because of delayed completion, potential loss of or postponement of tax benefits and other factors peculiar to the nature of the project or the owner's contemplated use should also be considered. Ideally, the owner should document the specific method by which the dollar amount of liquidated damages included in the contract was determined and advise the contractor of the method used before the contract is signed.

From the contractor's standpoint, he should be prepared to negotiate the liquidated damage amount by making plausible arguments in favor of reductions calculated to fix that amount realistically and by assuring that the contract completion date will provide sufficient time to complete - with some margin for contingencies.

Use of a liquidated damages provision based upon a reasonable completion schedule and realistic dollar figure may have worthwhile advantages to both the contractor and owner. However, the use and content of such a provision certainly requires careful study by both parties before the contract is signed.