If you’re a developer/owner, your first question when reading the title of this column is probably: “How can I get penalized by the liquidated damages on my construction project? Liquidated damages are supposed to protect my interests.” Liquidated damages are designed to protect owners, but if not enforced or drafted properly, they can be unenforceable, thus penalizing the owner.
If a construction project is not completed on time, it can have serious consequences. For the owner it can mean the loss of use and/or loss of income; financing damages; and increased project supervision costs. These types of damages are often difficult to calculate. Therefore, owners may want to fix these damages ahead of time by liquidating them. If done correctly, this will benefit the owner by establishing a known amount that it will compensated for late completion. On the other hand, liquidated damages may benefit the contractor by creating certainty in the event of delay and in some instances, perhaps reducing the contractor's exposure when the owner's actual delay damages are greater than the liquidated amount.
Liquidated damages are typically assessed against the contractor as a fixed amount on a per-day basis. In many instances, they are assessed in different amounts depending on the phase of the project. For example, liquidated damages might be set at $500 per day until substantial completion and drop down to $250 per day until final completion of the project. There is some logic to the phased-down damages since the owner can typically use and occupy the project following substantial completion.
If an owner's project is late due to no fault of his own, owners often assume the liquidated damages provision is a failsafe measure to recoup his losses. This is not always the case. Simply because the owner and contractor agree in writing to a fixed liquidated damages amount in the contract does not mean that a judge or arbitrator will enforce it when the project is late.
Liquidated damages that are a penalty are not legally enforceable. How can an owner tell if its liquidated damages may constitute a penalty? The test is whether the owner's damages were readily ascertainable at the time the contract was formed – meaning they could be determined at that time. If they were readily ascertainable, then there is a substantial risk that the liquidated damages will be an unenforceable.
When it comes to enforcing liquidated damages, an owner is not home free just because it passes the not-readily ascertainable test. There is a second prong of attack against these contract provisions. Namely, the liquidated damages can't be grossly disproportionate to the damages that might be expected to rise from a breach of the contract. If they are, the court may find that they were intended to pressure the contractor to perform timely rather than legitimately liquidating expected damages. If the owner can't establish that the damages agreed to in the contract bear some relation to actual anticipated damages, enforcement will be difficult. In addition, the court still may reject liquidated damages if enforcement of the liquidated damages would be unconscionable.
Typically, liquidated damages provisions will pass muster and be enforceable if they are not waived by the owner. Surprisingly, some owners go through the trouble of crafting enforceable liquidated damages provisions in the contract, but then don't follow the necessary steps to enforce them. What is required for effective enforcement? If the project is delayed and liquidated damages are accruing, the owner should notify the contractor promptly. An owner should avoid awarding extra work to the contractor while liquidated damages are accruing, unless an agreement can be reached as to how the damages will be handled in light of the extra work. If these two guidelines are not followed, the contractor may have a valid claim that the liquidated damages were waived.
— Kevin Fowler is a partner with Foley & Lardner LLP’s Orlando office.