This is the first in a three-part series on liquidated damages in construction contracts. This post addresses the various types of damages and how liquidated damages should be determined and specified. The second part will present an example of documenting the basis for liquidated damages. The final part will address enforcing liquidated damages during construction.
Construction contracts typically include a clause asserting that “time is of the essence” with respect to the contractor completing the work within the stipulated contract times. Most construction contracts also impose on the contractor “liquidated damages”, typically expressed as a stipulated amount per day, for each day the work is delayed beyond the established completion deadline (“contract time”). While just about everyone in the design and construction community is familiar with the term “liquidated damages,” less common is knowledge what liquidated damages truly are, what amounts are appropriate for them, and how and when they should be imposed.
What They Are and Are Not
There are various types of “damages” that arise on construction projects, including “liquidated damages,” “direct damages,” and “consequential damages.” It is important to understand the differences between them. Black’s Law Dictionary, Tenth Edition (2014), defines the following:
“Damages: Money claimed by, or ordered to be paid to, a person as compensation for loss or injury. <The plaintiff seeks $8,000 in damages from the defendant.>”
“Liquidated damages: An amount contractually stipulated as a reasonable estimation of actual damages to be recovered by one party if the other party breaches. If the parties to a contract have properly agreed on liquidated damages, the sum fixed is the measure of damages for a breach, whether it exceeds or falls short of the actual damages.”
Thus, liquidated damages are intended only to compensate. In a construction contract, liquidated damages are intended to reasonably “make the owner whole” and are not intended to punish (penalize) the contractor. Another basic aspect of liquidated damages is that the damaged party is not required to document or prove to the breaching party the amount of its actual damages. However, if challenged in litigation or other dispute resolution method, it may be necessary to document that the liquidated damages rate stated in the contract was a reasonable estimate of the anticipated actual damages.
Direct damages also sometimes termed “general damages” or “necessary damages,” are the actual costs incurred by the damaged party as a direct result of the breaching party’s failure to perform.
Black’s Law Dictionary also defines:
“Consequential damages: Losses that do not flow directly and immediately from an injurious act but that result indirectly from the act. Also termed indirect damages.”
What types of actual damages are direct or consequential may be subjective and the source of debate. For example, the owner of a new casino for which construction will be completed late may believe its profits not realized for each day the casino opens late arise directly and are reasonably foreseeable from the contractor’s late completion, whereas the contractor would likely argue such amounts are consequential. It may be worthwhile to distinguish in the contract the types of damages considered direct and consequential, because the contract may preclude recovery of certain types of damages.
Liquidated damages clauses typically serve to reduce or eliminate such arguments regarding delay damages.
When recovery of direct damages or consequential damages is pursued, the amounts of damages typically must be documented and substantiated. The claiming party must also typically prove the claimed damages (direct and consequential, when pursued) were incurred as a direct result of the breaching party’s action or inaction.
The idea behind liquidated damages clauses is to preclude recovery of direct damages and consequential damages. Many contracts expressly waive the parties’ rights to seek recovery of consequential damages. The rationale for liquidated damages precluding recovery of other damages for delays is to simplify and shorten the process for the damaged party to recover its costs. Indeed, when actual or consequential damages are pursued, often lengthy and expensive litigation or other dispute resolution procedures result.
As discussed in the next section of this blog post, the amount of liquidated damages should be appropriate for the damages reasonably anticipated due to the contractor’s late performance. Stipulation of excessive liquidated damages may, if challenged, be deemed an unenforceable penalty. Such decisions have resulted from litigation or arbitration of countless construction delay claims. To be enforceable, and not be construed as a penalty may require a corresponding bonus (incentive) clause, although the two amounts need not necessarily be identical.
Contractors typically prefer (or at least tolerate) an appropriate liquidated damages clause rather than face exposure to actual damages (i.e., direct and, perhaps, consequential damages). This is because liquidated damages are known and can be accounted for when pricing the work, whereas actual damages are an unknown that is not easily quantified. Actual damages are often disputed, which is often an expensive and time-consuming process. Furthermore, anyone experienced with delay claims, whether by contractors or owners, is familiar with how claimed damages often increase the longer the disagreement continues, as the damaged party seeks to buttress its case and its negotiating position. As discussed above, the line between direct damages and consequential damages may be open for interpretation and debate but liquidated damages are not. Therefore, contractors may be reluctant to accept provisions making them liable for actual damages for delays.
Specifying Liquidated Damages
Not all construction contracts include liquidated damages for late completion. When included, they are typically indicated in the owner-contractor agreement, as part of or adjacent to the contract times provisions. The standard construction contracts of the American Institute of Architects (AIA) stipulate only a contract time for substantial completion, whereas those of the Engineers Joint Contract Documents Committee (EJCDC) include contract times for substantial completion, final completion, and optional interim “milestones”. Depending on the project, liquidated damages may apply to any or all of the contract times.
AIA A101—2017, Standard Form of Agreement Between Owner and Contractor (Stipulated Sum), includes the following:
“§ 3.3.3 If the Contractor fails to achieve Substantial Completion as provided in this Section 3.3, liquidated damages, if any, shall be assessed as set forth in Section 4.5.
“§ 4.5 Liquidated damages, if any:
(Insert terms and conditions for liquidated damages, if any.)”
AIA presents model language for the “meat” of the Agreement’s Section 4.5.1 in AIA A503—2017/2019, Guide for Supplementary Conditions. A503 includes copious guidance notes and two alternative sets of model language: one for liquidated damages for failure to comply with a single contract time for substantial completion, and the second for contracts with multiple contract times for substantial completion. The first version is:
“If the Contractor fails to achieve Substantial Completion within the Contract Time, the Contractor shall be liable for the sum of ____ dollars ($____) as liquidated damages, and not as a penalty, for each calendar day beginning on the first day after the Contractor fails to achieve Substantial Completion within the Contract Time until the date that Substantial Completion is achieved.”
EJCDC C-520—2018, Agreement between Owner and Contractor for Construction Contract (Stipulated Price), addresses liquidated damages in greater detail, as follows:
“4.05 Liquidated Damages
“A. Contractor and Owner recognize that time is of the essence as stated in Paragraph 4.01 above and that Owner will suffer financial and other losses if the Work is not completed and Milestones not achieved within the Contract Times, as duly modified. The parties also recognize the delays, expense, and difficulties involved in proving, in a legal or arbitration proceeding, the actual loss suffered by Owner if the Work is not completed on time. Accordingly, instead of requiring any such proof, Owner and Contractor agree that as liquidated damages for delay (but not as a penalty):
“1. Substantial Completion: Contractor shall pay Owner $[number] for each day that expires after the time (as duly adjusted pursuant to the Contract) specified above for Substantial Completion, until the Work is substantially complete.
“2. Completion of Remaining Work: After Substantial Completion, if Contractor shall neglect, refuse, or fail to complete the remaining Work within the Contract Times (as duly adjusted pursuant to the Contract) for completion and readiness for final payment, Contractor shall pay Owner $[number] for each day that expires after such time until the Work is completed and ready for final payment.
“3. Milestones: Contractor shall pay Owner $[number] for each day that expires after the time (as duly adjusted pursuant to the Contract) specified above for achievement of Milestone 1, until Milestone 1 is achieved, or until the time specified for Substantial Completion is reached, at which time the rate indicated in Paragraph 4.05.A.1 will apply, rather than the Milestone rate.
- Liquidated damages for failing to timely attain Milestones, Substantial Completion, and final completion are not additive, and will not be imposed concurrently.
“B. If Owner recovers liquidated damages for a delay in completion by Contractor, then such liquidated damages are Owner’s sole and exclusive remedy for such delay, and Owner is precluded from recovering any other damages, whether actual, direct, excess, or consequential, for such delay, except for special damages (if any) specified in this Agreement.”.
EJCDC C-520 also includes associated guidance notes regarding damages clauses and optional language for “special damages”, which are conditional damages to compensate the owner for civil fines and penalties incurred due to the contractor’s actions or late performance or, on some projects, for the owner to recover the cost of engineering and inspection fees incurred for completion beyond the contract times, where such amounts are not included in the liquidated damages. When owners insist on specifying low liquidated damages, perhaps to help keep bid prices low, EJCDC’s model language for “special damages” assists the owner in obtaining reimbursement for its losses.
The amount stipulated for liquidated damages should be specific to the project. One-size-fits-all amounts and rounded-off numbers that “sound good”, but are really plucked from the air, should be avoided. When challenged via litigation or arbitration, liquidated damages that are not based on a documented, rational estimate of the damages the owner reasonably expected to incur in the event of late completion are likely to be deemed a penalty. Courts and arbitrators have often ruled that such liquidated damages are unenforceable.
For the best potential that liquidated damages, if challenged in a dispute, will be enforceable, the amount stipulated in the contract should be:
- A rational estimate of the damages the owner reasonably expects to incur due to the contractor’s late performance.
- Documented in a design phase memorandum in the files of both the owner and design professional.
- Specific to the project, even when the owner and design professional have a history of implementing capital projects together.
Some construction contracts establish an increasing rate of liquidated damages as time elapses between the contract time and completion; e.g., “Liquidated damages shall be $1,000 per day for the first 30 days after the Contract Time, and $2,000 per day starting on the 31st day after the Contract Time, until Substantial Completion is achieved.” Such damages are likely to be challenged as punitive and unenforceable if they do not directly correlate to the direct damages the owner would reasonably expect to incur.
Another common approach is a schedule of pre-determined liquidated damages based on the contract price, such as, “For Contractor’s failure to achieve Substantial Completion by the Contract Time, liquidated damages shall be as follows: $500 per day when the Contract Price is $1,000,000 or less; $1,500 per day when the Contract Price is $1,000,001 to $5,000,000;,$2,500 per day when the Contract Price is $5,000,001 to $10,000,000.” Such provisions may be considered arbitrary and capricious and therefore unenforceable, because they appear to have little or no connection to the amount the owner might reasonably expect to be damaged due to the contractor’s late performance. However, this approach is fairly common, especially in construction contracts issued by state departments of transportation. Despite their frequent use, this writer recommends against rigid, formulaic linking of the liquidated damages rate to the contract price.
Owners and design professionals should recognize that liquidated damages have strong potential to affect the prices bid or proposed by prospective contractors. Contract times should be sufficient for the required work (see: Stipulated Contract Times: Determination Requires Due Diligence); it is usually advisable for the owner or design professional to prepare a preliminary construction schedule during the project’s design stage to identify the appropriate contract times. When the contract times are insufficient, bidders are likely to include in their bids a contingency for the probable total amount of liquidated damages they expect to incur. Also, stipulated liquidated damages should be commensurate with the project’s scope and construction price. For example, a project with an expected construction price of $100,000 that has stipulated liquidated damages of $5,000 per day may attract few bidders because the risk would likely be disproportionate to the contractor’s reward. Also, the liquidated damages amount might be unenforceable if it is deemed an excessive penalty rather than a good-faith attempt to estimate actual damages.
When the owner will incur financial loss or “damage” due to the contractor’s late performance, an appropriate liquidated damages clause in the owner-contractor agreement can greatly simplify the process of properly compensating the owner. To be enforceable if challenged via a claim or dispute, the amount of liquidated damages must be specific to the project and based on a rational, design stage estimate of the damages the owner would reasonably incur. The basis for such damages should be clearly documented in the owner’s and design professional’s project files.
Forthcoming posts in this series will: (1) present an example of design phase documentation of the basis for liquidated and special damages; and (2) address enforcement of liquidated damages during construction
Acknowledgments: The author gratefully acknowledges Jerry Cavaluzzi, Esq., vice president and general counsel of Kennedy/Jenks Consultants; Jim Brown, PE, CSI, CCCA, vice president of construction management at Arcadis; and Hugh Anderson, Esq., attorney-at-law and general counsel to EJCDC, for reviewing and commenting on drafts of this post.
Copyright 2021 by Kevin O’Beirne
The content of this blog post is by the author alone and should not be attributed to any other individual or entity.
Kevin O’Beirne, PE, FCSI, CCS, CCCA is a professional engineer licensed in NY and PA with over 30 years of experience designing and constructing water and wastewater infrastructure for public and private clients. He is the engineering specifications manager for a global engineering and architecture design firm. He is a member of various CSI national committees and is the certification chair of CSI’s Buffalo-Western New York Chapter. He is an ACEC voting delegate in the Engineers Joint Contract Documents Committee (EJCDC) and lives and works in the Buffalo NY area. Kevin O’Beirne’s LinkedIn page.