Who's afraid of liquidated damages?

There are many reasons why liquidated damages, or at least a liquidated damages clause, can be a good thing — if you know a little about them.

Contractors often bemoan the topic of liquidated damages. This is understandable if you have ever had to pay them. But the idea of liquidated damages should not be something to fear. In fact, there are many reasons why liquidated damages, or at least a liquidated damages clause, can be a good thing — if you know a little about them.

The term "liquidate damages" refers to agreed amounts of money that are payable by a party who does not meet certain types of obligations under a contract. Liquidated damages are generally used when it would be difficult or impossible for one of the parties, usually the owner or general, to prove actual damages in the event the contractor or subcontractor does not meet its obligations. So, at the time they enter their contract, the parties agree on what they believe to be a reasonable estimate of any potential damages and that is the amount the contractor pays if, for example, it delays the project or delivers equipment or materials past agreed deadlines.

So how does a liquidated damages clause benefit the contractor? Well, it should go without saying that it is best to avoid having to pay liquidated damages in the first place. But as hard as a contractor may try, and as much as a contractor may plan and prepare, there is no guarantee that it will not get behind schedule or miss critical deadlines. In that case, if you do breach your contract, it is often better to pay an agreed amount of liquidated damages than some unknown amount of actual damages. Think about the losses, or actual damages, an owner might incur — or which a general contractor might pass through — for delays to the opening of a casino, power plant or hotel. These losses can be astronomical as well as unpredictable.

This is not necessarily true for liquidated damages. With liquidated damages, at least you know what your exposure is ahead of time. And, at least theoretically, it's an amount you negotiated and can manage — otherwise the wise contractor might not sign the contract in the first place. So liquidated damages can provide a greater degree of certainty, allowing a contractor to better manage risk and to avoid potentially catastrophic exposure to actual damages.

But this isn’t all you need to know. The next time an owner or general contractor insists on a liquidated damages clause in your contract, there are some things to consider. To begin with, determine the purpose of the proposed liquidated damages. Are they to compensate the owner for delays to opening or for delays to production? What type of actual damages is the liquidated damages intended to replace? For example, are they for critical path delays, failure to meet milestones, or for late delivery of equipment or materials?

Next, make sure the amount of proposed liquidated damages seems reasonable based on the intended purpose. Make sure they seem reasonable in light of the amount of damages the owner or general contractor expects to incur if you don’t timely perform your contractual obligations. If the proposed liquidated damages seem too high, this should be a topic for discussion. And watch out for pass through clauses in your subcontract — these could be written in ways that they appear very general and might not be specific to liquidate damages, but could apply in a way that would pass through any liquidated damages that could be imposed under the prime contract.

To the extent of your bargaining power, you can try to negotiate the specific amount of liquidated damages. This can be easier if you are a prime contractor or large supplier. It can be more difficult if you're a subcontractor. At a minimum, make sure your subcontract doesn't just pass through all owner imposed liquidated damages. Make sure you are responsible only for those amounts you are responsible for causing.

And don't forget about caps. You can negotiate a limitation on the amount of liquidated damages for which you will be responsible if you breach your contract. Combine the use of a cap with a statement that liquidated damages are the owner's or general's "exclusive remedy" for delays or late delivery, and you can limit your ultimate exposure in the event you miss a deadline or delay the project. Knowing your ultimate exposure for delays can help you decide whether to sign the contract or not. And, if you do sign the contract, it can be very helpful when making decisions about resource allocation between various projects.

So don't panic the next time an owner or general contractor insists on a liquidated damages clause in your contract. Instead, embrace the idea as an opportunity to manage your risk, and then negotiate the best deal you can. You might even propose the idea yourself as a way to control and manage risk.

Michael Callahan is a partner at Stinson Morrison Hecker LLP (the same firm as long-time columnist Susan McGreevy) where he assists clients with all aspects of their construction law needs, including litigation.