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The Enforceability of Liquidated Damages Clauses

Large construction project contracts typically involve complex scopes of work and rigorous completion deadlines. Liquidated damages clauses serve as an important protection for the owner and negative incentive for the contractor to achieve timely completion.

Project delays often lead to contractor claims for time extensions and additional compensation, as well as give rise to owner claims because time is money and delays adversely affect the owner’s interests too.

When a contract includes a liquidated damages clause, the owner’s claim will be calculated at the stipulated daily liquidated damages rate times the number of days of inexcusable delay as provided for in the liquidated damages clause. Typically, the larger the contract amount, the higher the liquidated damages amount. The higher the liquidated damages amount, the greater the owner’s claim. When faced with a substantial owner liquidated damages claim, astute contractors and their counsel will look for a way to attack the enforceability of the liquidated damages clause. Whether such an attack succeeds depends on a number of factors.

To be enforceable, a liquidated damages provision must be a reasonable estimate of the damages an owner would incur if the contractor fails to complete the project by the required completion date. If the liquidated damages amount is unreasonable and considered an attempt to coerce or penalize the contractor, the clause will be deemed an unenforceable “penalty.”

U.S. courts take two approaches when determining the enforceability of a liquidated damages clause. A majority of courts use a “prospective” approach that looks at the reasonableness of the liquidated damages amount as of the time the parties entered into the contract. If the amount was a reasonable estimate at the time of contract formation, it will be enforced, regardless of the actual damages.

A minority of U.S. courts use a “retrospective” approach, which determines the reasonableness of the liquidated damages provision based on the facts at project completion. In this case, a liquidated damages amount that was reasonable when the parties entered into the contract may be held to be an unenforceable penalty if the amount is way off kilter at the time of the delay in completion compared to the actual damages being incurred by the owner.

In one recent case, the owner of a power plant collected more than $20 million in liquidated damages from its EPC contractor. An arbitration panel dismissed the EPC contractor’s assertion that the recovery of the stipulated liquidated damages amount would result in a windfall for the owner because of a change in power market economics.

Under New York law, enforceability of liquidated damages amounts is determined prospectively (at the time of contract formation). In this case, the owner presented substantial evidence to support the $149,000-a-day liquidated damages amount in the contract. The evidence included a contract negotiation team and consultants, as well as expert testimony in the field of economics and other contemporaneous documentation—all for the purpose of proving the reasonableness of the $149,000-per-day calculation. The arbitration panel concluded “the quantum of damages proposed must be shown to be unreasonable at the time that the contract between the parties was negotiated” and the evidence clearly established the amount stipulated by the parties in the contract was reasonable at the time the contract was formed.

Because the enforceability of liquidated damages is determined based on the reasonableness of the amount, it is imperative for an owner to document the specific elements of the estimate used by the parties to establish the amount. Written records should include spreadsheets, notes, correspondence and other data that best represent the manner in which the per diem amount was developed.

In the retrospective approach used in some jurisdictions, such as Texas, reasonableness is determined by comparing the stipulated liquidated damages amount to the actual delay damages amount incurred at project completion. Courts following the minority approach will uphold a liquidated damages clause only if it is proportionate to the actual damages incurred by the owner—regardless of the reasonableness of the estimate at the time of completion.

Liquidated damages clauses also can be voided if the amount “shocks the conscience” of the court. If the liquidated damages amount is too high compared to the value of the contract itself, the liquidated damages will be deemed unenforceable.

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