Considering all that can go wrong on a construction site, it can seem like a miracle that anything is ever built. Construction projects can be massive undertakings, often with millions of dollars at stake, requiring the coordination of thousands of people. The glue that holds the organized chaos together is found in the contracts.

Apart from detailing project specifications and setting the price, the primary purpose of a contract is to provide a means for the parties to apportion the high degree of risk inherent to any construction undertaking on the front end of a project. Apportioning risk gives at least some certainty and predictability to what would otherwise be a dizzying array of responsibilities, deadlines, and potential liabilities.

One way in which construction contracts apportion risk is through liquidated damages clauses. Liquidated damages are a way for the owner and the contractor to agree beforehand to the amount of damages that the contractor will owe to the owner if there is a delay in completing the project. For example, a liquidated damages clause might state that a contractor will owe the owner $500 per day for every day past the project deadline that substantial completion is not achieved. This contractual solution can be advantageous for both parties. A liquidated damages clause relieves the owner of the often difficult and time-consuming process of calculating and proving its actual damages by “liquidating” these damages to a number that is explicitly stated in the contract.

A liquidated damages clause can be advantageous for contractors as well. How so? Without a liquidated damages clause, a contractor faces uncertainty as to the cost of any potential delay. This uncertainty makes it difficult for the contractor to adequately price its risk when calculating its bid. In response to this uncertainty, a contractor will likely raise or cushion its bid price to account for the unknown risk associated with potential delays. A liquidated damages clause transforms this unknown risk into a known risk, allowing the contractor to price the risk more accurately and therefore bid on the project more efficiently. The contractor can also attempt to pass all or portions of this known risk down to subcontractors through a variety of subcontract clauses.

Given the important role liquidated damages clauses serve in construction contracting, it is no surprise that they are often found at the center of construction disputes. Typically, these disputes involve a contractor arguing that the amount of liquidated damages imposed by the contract is too high because the owner’s actual damages due to delay on the project are much smaller. Keeping the practical rationale behind liquidated damages clauses in mind can help owners and contractors better understand the law behind the enforceability of liquidated damages clauses in construction contracts.

Liquidated damages provisions fundamentally exist to promote efficiency in contracting. Their purpose is not to serve as a tool in the hands of the owner to punish the contractor for failing to complete the project on time. For this reason, in Oregon and in most states, liquidated damages must be reasonable in light of the anticipated or actual harm caused by the contractor’s delay to be enforceable. The “reasonableness” of the damage amount is judged against what is known at the time the contract is entered. Courts will always find that a contract term fixing an unreasonably large sum as liquidated damages is unenforceable because in such a case, the clause is operating as a penalty for the contractor’s delay and not as an estimate of the actual damages incurred by the owner.

But what about the other way around? Can an owner get a court to declare a liquidated damages provision unenforceable for being an unreasonably small sum and recover instead for its actual damages on a project? In theory, yes. Although this situation is comparatively rare, it is possible in many states for a court to find a liquidated damages clause unenforceable because the amount under the contract is too small to have been a reasonable anticipation of the actual harm caused by a contractor’s delay when viewed at the time of contracting.

Careful drafting, however, can help to avoid these types of disputes altogether. Ideally, a liquidated damages provision should not be a weapon in the hands of either a project’s owner or contractor. Owners and contractors can draft better liquidated damages clauses that serve the overall needs of the project and avoid costly disputes over enforcement by approaching these clauses as mutually beneficial tools designed to promote efficiency. A carefully negotiated and well-drafted liquidated damages clause provides a known quantity that both parties can plan for and rely on and helps both parties achieve their ultimate goal of completing the project on time while generating a profit.

Originally published by the Daily Journal of Commerce on December 14, 2023.