Liquidated damages must relate to actual ones

LIQUIDATED DAMAGES are an acknowledged part of life in the construction industry. While people in other lines of work might be surprised that anyone would agree to a pre-set daily fee for something as minor as being late in delivering goods or services, in construction there are good reasons for making such an agreement. They give certainty and predictability to a risk. If classrooms are overcrowded

LIQUIDATED DAMAGES are an acknowledged part of life in the construction industry. While people in other lines of work might be surprised that anyone would agree to a pre-set daily fee for something as minor as being late in delivering goods or services, in construction there are good reasons for making such an agreement. They give certainty and predictability to a risk. If classrooms are overcrowded because the new school wasn't finished on time, the school district would have a hard time proving a dollar amount to collect damages. Conversely, contractors prefer liquidated damages on highrisk work such as hotels or casinos because LDs limit their liability to a known dollar amount.

And they are not negotiable, so if you want the business, you agree.

Initally courts didn't like these preset agreements on damages because they seldom work out to be the same as the actual damages (generally, they are greater), and where they are less than the actual damages, they amount to no more than a penalty or fine for late completion. Generally, fines and penalties are for the government to impose,-not private parties. With the federal-boards of contract appeals taking the lead, however, courts are now pretty used to liquidated damages and regularly enforce them.

Lately, however, we have been seeing clauses that are getting a little too cute — to the point where they may not be enforceable at all. For example: A municipality calculates that its actual damages would be about $15,000 per day for late completion of a convention center. On a CM job, each trade contractor agrees to $15,000 per day. When more than one contractor contributes to the delay, the contracts provide that each one can be assessed the entire daily rate, giving the city double, triple or more its actual damages. Not enforceable.

The state is tired of defaults on small contracts, so it provides that liquidated damages will stop at substantial completion of large jobs but continue until final completion on jobs less than $500,000 to "incentivize" the contractors to complete them. Clearly, there's no relation to actual damages so this is a penalty.

Setting the rate too high can backfire as well.

A hospital provides for liquidated damages of $1,000 per day for late completion of a remodel job. It takes partial occupancy of the completed portion, and pro-rates the LDs for the part that was not complete. Not enforceable because there was no evidence as to which parts of the project were worth which dollars.

A county pays a contractor to dam a small stream, with the intention that when it creates a pond that could take six months to a year to fill, it would provide a source of water for its municipal golf course starting the spring after it fills up. The contractor was assessed $1,500 per day for its two weeks' delay in completion, but that two weeks could not be tied in any way to a loss of use of the pond. The clause is not enforceable as there's no evidence the daily rate was tied to this delay.

In each of these cases, the clause might have been enforceable had it been better drafted.

An owner who wants to take partial occupancy could offer the contractor a reduced LD rate for the rest of the work, and the contractor would generally be glad to get it, since it reduces its risk for any remaining delay.

The state with the problem getting small jobs completed could use a higher retention, or put more teeth into its suspension or debarment procedures.

The multiple prime project owner has the same problem that all general contractors and upper-tier subcontractors have of how to apportion damages when more than one party contributed to the delay. ( Hint: Keep detailed records!)

The golf course owner should have spent time talking through its schedule and actual potential damages with its lawyer to come up with a clause that makes sense.

The amount of the daily rate can also lead to problems. Setting the amount too low takes away the incentive to put one job ahead of another. Contractors are not fools (well, most of them anyway) and they can calculate when it is in their interest to pay overtime, pull off of another job to finish this one and figure out where it is cheaper to just pay the LDs than to finish on time. Setting the rate too high can backfire as well. As I said above, courts are now used to these clauses and some will enforce them automatically, but owners still should be cautious in drafting them — as the saying goes, "Pigs get fat while hogs get slaughtered." Setting an amount high enough to scare a contractor into performing also may end up scaring contractors away from bidding, leaving an owner with a higher price and with a clause that a court won't enforce anyway.

To assure enforcement, a prudent owner will have some sort of calculation in its files showing how it arrived at the daily rate (estimated extra architect/engineer fees, additional rent or storage fees, labor charges, etc.). It will also consider having a separate, lower rate for loss of use of incomplete items after substantial completion.

The lesson here is that liquidated damages clauses can be effective tools for both the contractor and the owner, but instead of just pulling a number out of the air and sticking it in, it should really be tailored to reflect the estimated cost of delay. Then, a contractor can readily figure out if it is worth the risk to agree to it.

Susan McGreevy is a partner at Husch & Eppenberger, Kansas City, Mo., tel. 816/421-4800, e-mail to susan. [email protected].

TAGS: Law