This is the third post in our “Top 10 Construction Contract Provisions” series. Read our prior blog articles about Scope of Work and Indemnity clauses. Both a sword and a shield, a well-crafted liquidated damages clause can significantly simplify one of the most common sources of construction disputes-delay-and, in some cases, even keep disputes from boiling over into litigation or arbitration.
Contract Damages Law
Without a liquidated damages clause, a party breaching a contract is typically legally bound to pay the other party money damages in an amount sufficient to give the other party “the benefit of the bargain.” That is, the non-breaching party must be compensated so s/he is placed in the same position as if the other party had fully performed the contract.[i]
In practice, damages resulting from a breach of contract-especially construction delay-are often difficult to quantify with precision. The damage calculation implicates a variety of questions, such as, what revenues did the non-breaching party lose due to the breach? How certain were those revenues? During what period of time was revenue lost? What extra costs did the non-breaching party incur? What costs were avoided as a result of the breach (e.g. the balance of the contract)? Did the non-breaching party take reasonable measures to mitigate its damages?[ii]
For a construction project owner, every additional day in construction may carry additional financing costs, including extended cost to occupy alternative facilities, lost opportunities to sell the finished project, lost revenues from operation of the project (e.g. rents, manufacturing / production, retail sales, tickets / admissions, etc.), decreased funding availability, missed market opportunities, or countless other costs depending on the nature of the project. For a contractor, more time on a project often means more labor, project management, rentals, subcontractor costs, overhead, opportunity costs (e.g. lost revenues from other projects), and other costs.
With so many potential factors in play, even on a relatively simple project, a dispute about the monetary impact of delays can damage relationships, prevent successful completion, and spawn costly litigation.
At its most basic level, a liquidated damages provision is an agreement to forgo potential disputes about actual damages in the event of a breach, instead stipulating in advance to a reasonable estimate of the probable damages.
In Washington, such an agreement is legally enforceable if (1) the amount fixed is a reasonable forecast of just compensation for the harm caused by the breach, and (2) the harm is incapable or very difficult of ascertainment.[iii] The reasonableness of the forecast is judged from the time of the agreement.[iv]
Consistent with the requirement that the liquidated damages amount be a reasonable advance estimate, a liquidated damage provision will not be upheld if it amounts to a penalty.[v]
A Fair and Balanced Liquidated Damage Clause
While each party’s interest obviously lies in obtaining the most favorable liquidated damages amount or rate and conditions under which liquidated damages will be imposed, a relatively balanced liquidated damages provision will include the following elements:
1. Clear definition of when liquidated damages will apply. This can be based on a specified duration (e.g. substantial completion achieved within 180 days from receipt of a Notice to Proceed) or a date certain (July 30, 2014). The provision can also account for potential changes and schedule adjustments. It is also worth observing that while construction contracts most often apply liquidated damages to delays in completion, liquidated damages can be stipulated for nearly any kind of breach.[vi]
2. Reasonable Amount or Rate. What liquidated damages amount is reasonable is a project-specific inquiry and may be influenced by a variety of factors, such as, anticipated financing costs to carry the project beyond the contractual completion date, daily project “burn rates,” anticipated additional project management / consultant costs, extended overhead, liquidated damages imposed by upstream contracts, sales market trends, pre-scheduled uses of the project (e.g. special events, school years, etc.), projected lost revenues, cost of alternative space, opportunity costs, etc.
3. Exclusivity. With the parties stipulating to a predetermined estimate to reduce potential later disputes about actual damages-and with the project presumably priced consistent with the agreed risk allocation-it is generally desirable to clarify that the liquidated damages are the sole and exclusive remedy for the specified performance failure.
4. Caps. Although often overlooked as a possibility, a cap on the aggregate liquidated damages provides another means to bring balance and predictability. Liquidated damages may be capped, for example, in an amount equal to the contractor’s fee, the total contract price, or any other amount that may be justified under the circumstances.
With these points in view, one example of a balanced provision is as follows:
[Contractor] [Subcontractor] understands that if the Substantial Completion is not achieved [by ________] [within ________ days of receipt of the Notice to Proceed] [within _______ days of the date Subcontractor has uninhibited access to all areas required to perform the Work], as such date or duration may be amended by subsequent Change Order, [Owner] [Contractor] will suffer damages which are difficult to determine and accurately specify. [Contractor] [Subcontractor] agrees that if the date or duration set forth above in this paragraph is not attained, [Contractor] [Subcontractor] shall pay [Owner] [Contractor] $[_____] as liquidated damages and not as a penalty for each day that Substantial Completion extends beyond such date or duration. The liquidated damages provided herein shall be in lieu of all liability for extra costs, losses, expenses, claims, penalties, and other damages incurred by [Owner] [Contractor] which are occasioned by delay in [Contractor] [Subcontractor]’s performance or in achieving Substantial Completion within the prescribed timeframe. In no event shall the total liquidated damages exceed $[_____].
Comment: Few contract clauses give both contractors and courts such apparent heartburn as liquidated damages. Contractors often view liquidated damages as a penalty threatened to ensure timely performance, despite clear law that liquidated damages are unenforceable if they constitute a penalty rather than a fair estimate of damages. In truth, as indicated above, liquidated damages just as often reduce risk by offering certainty in the event of non-performance and protect the contractor against monetary consequences that may be out of its direct control. Courts, meanwhile, struggle with the conflicting legal principles that, on one hand, contract-based damages are intended to compensate the non-breaching party rather than punish the breaching party and, on the other hand, the law binds parties to perform their contractual undertakings (i.e. the “freedom of contract”).[vii] Steering clear of these tensions, a balanced clause imposing a fair estimate of damages anticipated from a delay or other breach can be an invaluable tool to protect contracting parties’ expectations, manage risk, and streamline potential disputes.
[i] See, e.g., Rathke v. Roberts, 33 Wn.2d 858, 207 P.2d 716 (1949).
[ii] “The doctrine of mitigation of damages, or avoidable consequences, prevents an injured party from recovering damages that the injured party could have avoided if it had taken reasonable efforts after the wrong was committed.” TransAlta Centralia Generation LLC v. Sicklesteel Cranes, Inc., 134 Wn.App. 819, 825-26, 142 P.3d 209 (2006).
[iii] Watson v. Ingram, 124 Wn.2d 845, 850, 881 P.2d 247 (1994).
[iv] Id.; see also, Wallace Real Estate Inv., Inc. v. Graves, 124 Wn.2d 881, 881 P.2d 1010 (1994).
[v] Wallace Real Estate Inv., Inc., 124 Wn.2d at 886; Walter Implement, Inc. v. Focht, 107 Wn.2d 553, 558, 730 P.2d 1340 (1987); Buchanan v. Kettner, 97 Wn.App. 370, 373-74, 984 P.2d 1047 (1999); Brower Co. v. Garrison, 2 Wn.App. 424, 432, 468 P.2d 469 (1970).
[vi] For example, liquidated damages may be agreed to for earnest money in real estate purchases and sales, which Washington statutory law specifically declares enforceable up to 5% of the purchase price. RCW 64.04.005.
[vii] See, e.g., Sturges v. Crowninshield, 17 U.S. 122, 4 L.Ed. 529 (1819); U.S. Const., Art. 1, § 10; Wash. Const., Art. 1, § 23; Wallace Real Estate Inv., Inc., 124 Wn.2d at 890-91; see also, Susan V. Ferris, Liquidated Damages Recovery under the Restatement (Second) of Contracts, 67 Cornell L. Rev. 862 (1982).