Liquidated Damages – Carefully Crafted to Avoid Litigation

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Necessity may be the mother of invention, but uncertainty is certainly the mother of litigation.  In the context of construction contracts, the uncertainty that most often results in an expensive trial is not whether a party breached an agreement; rather it is the amount of damages the non-breaching party may reasonably expect to recover.  The breach of a commercial construction contract typically results in two categories of damages – direct and consequential.  When drafting a construction contract, direct damages are easy to anticipate and calculate.  By way of example, a direct damage would be the actual cost to repair or replace a contractor’s work.  In the event a contractor stopped performing or was removed from a project, the direct damage would be the additional cost to complete the contractor’s work over the original contract price.

The more difficult task, however, is anticipating the nature and extent of consequential damages that a party may suffer in the event a project is not completed in a timely manner.  Will the delay result in lost profits?  How would such profits be estimated?  What if the project is a new business without an established record of profits?  Would delayed completion damage the business reputation and good will of the non-breaching party?    

A contractor found liable for an owner’s lost profits could be forced to pay a judgment far in excess of the original contract price, much less any profit that the contractor could have expected to realize if the project had been performed properly.  On the other hand, an owner, especially one of a new business venture, risks being precluded from recovering its lost profits if a court determines that such amounts cannot be reasonably estimated.  In order to avoid either extreme, parties may contractually waive consequential damages and agree on pre-determined liquidated damage in the event of breach.

Ordinarily, parties may agree to set liquidated damages as either a lump sum amount, an amount based on the period of delay, or a hybrid of the two.  Parties could agree that liquidated damages are $50,000 in the event of breach; or $250 per day for each day the project remains incomplete after the agreed date of substantial completion; or $15,000 in event of breach and $100 per day until the project is complete.  To have an enforceable liquidated damage clause, be mindful of the following before executing the contract:

  1. Unable to Reasonably Estimate.  The liquidated damage provision must clearly articulate that consequential damages are uncertain and difficult to determine with exactness at the time of the agreement.  It is immaterial if, months after the contract has been signed, the parties are able to calculate consequential damages with certitude, and such actual damages either exceed or are inferior to the agreed upon liquidated damage amount.  The enforceability of the liquidated damage provision will turn on whether the parties were able to reasonably approximate the loss anticipated at the time of making the contract.  If such amount cannot be reasonably calculated, the liquidated damage clause will be enforced.

  2. Avoid the Absurd.  The liquidated damage clause should state that the parties agree that the amount fixed is fair, not out of all proportion to the probable loss, and not a penalty.  Such language, however, is not unassailable.  Although liquidated damages are premised on the notion that actual damages cannot be determined at the time of contract, parties should guard against overvaluing the recovery available pursuant to a liquidated damage provision.  If the agreed amount would be grossly in excess of actual consequential damages, courts will construe such an agreement to be an unenforceable penalty.  By way of example, if a $500,000.00 contract for the construction of a fast food restaurant assesses $1,000,000.00 per day in liquidated damages, a court will more than likely deem such a clause to be an unenforceable penalty.

  3. Sole Remedy.  The liquidated damage clause should state that, in the event of breach, the parties waive all claims to consequential damages, and the liquidated damage clause is the non-breaching party’s exclusive remedy.  Some jurisdictions, including Virginia, have a presumption against liquidated damages constituting the non-breaching party’s only remedy for consequential damages in the event of breach.  In other words, if a contract does not contain clear language to the contrary, a non-breaching party has the option of pursuing liquidated damages or its actual consequential damages in addition to its direct damages at trial.  The underlying purpose of a liquidated damages clause is to avoid a subsequent dispute regarding the determination of a non-breaching party’s actual consequential damages.  Such disputes over actual consequential damages can substantially increase a party’s legal fees.  Failing to make clear that liquidated damages are the exclusive means of recovery defeats the entire purpose of the provision. 

Without question, there is risk to both parties agreeing to liquidated damages.  The non-breaching party may not be made whole.  Conversely, liquidated damages may result in a payment larger than what would have been due if damages had been based on the actual harm caused by the delay.  

Such risks do not outweigh the benefit of certitude of result.  A carefully drafted liquidated damage provision results in fairness to both parties to a commercial construction contract.  The non-breaching party is assured that it will recover some amount for the damage incurred by delay, while the breaching party limits its exposure to an adverse verdict, allowing both parties to avoid or substantially reduce the probable cost of litigation.

Topics:  Breach of Contract, Damages, Liquidated Damages

Published In: Civil Remedies Updates, General Business Updates, Construction Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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